budgets and balance sheets: your personal financial statements © 2010 pearson education, inc. all...

Budgets and Balance Sheets: Your Personal Financial Statements

Chapter 4

Learning Objectives

• Explain the steps involved in creating a budget

• Explain the steps involved in creating a personal balance sheet

• Analyze the importance of budgeting in your financial plan

Creating a Budget

• A budget is a forecast of future cash inflows and outflows

• Creating a budget is a key part of your financial plan

• A budget provides guidance for reaching your personal goals

• It gives you a detailed roadmap to your financial future

Step 1: Create a Personal Cash Flow Statement

• Identify your current cash inflows and cash outflows

• Many cash inflows include salary, hourly wages, or allowance

• Cash outflows include car payment, rent, or phone bill

• See Figure 4.1 for an example of a Personal Cash Flow Statement

Figure 4.1

Step 2: Turning Your Cash Flow Statement into a Budget

• Forecast your net cash flows for a period a time into the future

• Think of how the cash flows might change from month to month

• Be sure to include expected, yet irregular expenses, such as school activity fees or vacation

Step 2: Turning Your Cash Flow Statement into a Budget

• A good budget should include unexpected expenses• Adjust the budget as necessary as you get more

information• An annual budget helps identify times where you

can save money and times when you will be spending more money

• See Figure 4.2 for an example of an annual budget

Figure 4.2

Working with and Improving Your Budget

• A budget will help you save money for:– major purchases– unexpected expenses– unexpected opportunities

• A budget will help you anticipate future cash shortfalls

• A budget is a great planning tool

Assessing the Accuracy of the Budget

• A forecast error is the difference between what you forecast to happen and what actually happened

• Evaluate your forecasts and compare those with the actual cash flows

• Keep an expense journal to track your spending

• After looking at your forecast error, you may need to adjust your spending

• Look at Figure 4.3 for an example forecast errors

Figure 4.3

Check Your Financial IQ

• What are the steps involved in creating a budget?

• Step 1: Creating a personal cash flow statement

• Step 2: Turning a cash flow statement into a budget

• Step 3: Working with and improving your budget

Personal Balance Sheet

• Personal balance sheet tells you what your financial position is at a point in time.

• A personal balance sheet helps you make decisions on how to use extra money

• Knowing where you are financially will help guide in deciding how to manage:– your liquidity – your use of credit and borrowing,– your investments– and more

Assets

• Assets on a balance sheet can be classified in several ways:– Liquid assets– Household assets– investments

Liquid Assets

• Liquid assets are financial assets that are either cash or can be easily converted to cash without significant loss of value

• Liquid assets include money in checking and savings accounts

• They are necessary for covering unexpected emergency expenses

• It is important that they have quick availability,

• It is also important for them to be making money

Math for Personal Finance

• Jeff has $1,000 in a savings account, $340 in his checking account, and $2,100 in stock that his grandmother gave him. He also owns his car, which is worth about 43,200

• How much does Jeff have in liquid assets?

• Solution: Jeff’s liquid assets consist of the money in his savings and checking accounts, which is $1,000 + $340 = $1,340.

Household Assets

• Household assets include those assets owned by a household – cars, houses, furniture

• The market value of something is what it would be worth if you sold it today

• Another type of asset is household assets

• While creating your personal balance sheet, evaluate the true market value of these assets

• Kelley Blue Book (for cars), EBay, and other internet sites are good resources for determining the value of these assets

Investments

• An investment is something you acquire with the ultimate goal of making money

• Investments are the third major category of assets

• Investments are something you buy that you believe will increase in value over time

• Some common investment assets are: – Stocks– Bonds– Real estate

Investments

• Bonds are basically certificates that function like IOUs—promises to repay a certain amount of money at some future time

• When you buy a bond, you are essentially loaning the issuer money

• The issuer pays you interest until the maturity date

• People buy bonds expecting to receive interest income while they hold the bond and getting their money back when the bond matures

• Investing in bonds involves some risks

Investments

• Stocks are certificates that represent fractional ownership of a firm

• People buy stocks expecting that the company will do well and the value will increase

• Each share of ownership represents a percentage of the business and is called a share of stock

• Stocks can be risky• It is possible that the value will

decline or disappear altogether

• Emily owns 50 shares of Company Y’s stock that is currently selling for $170 a share. She also owns 65 shares of Company Z’s stock worth about $47 a share.

• What is the total value of her stock holdings?

• Solution:

Company Y

50 x $170 = $8,500

Company Z

65 x $47 = $3,055

Total = $11,555

Investments

• Mutual funds are created so investors can pool their money in order to invest in a larger variety of financial assets, such as stocks and bonds from many different companies

• Mutual funds are managed by professionals who decide which stocks/bonds to purchase

• Individual investors who buy shares in the fund do not have to be experts in stock or bond selection

• The risk of loss is usually spread across many different investments

Investments

• Real estate includes homes, rental property, farms, and other land

• Real estate is another type of investment

• People invest in this hoping it will generate revenue over time and increase in value

Liabilities

• Liabilities represent the amount of debt a person owes

• These debts can be put into 2 categories: – Current liabilities– Long-term liabilities

Liabilities

• Current liabilities are debts that must be paid off within 1 year

• Credit card balances are the most common form of current liabilities for people

• A credit card acts like a short term loan that “should” be paid of every month

• When you pay the credit card bill, you are eliminating the current liability

Liabilities

• Long-term liabilities are debt that will take longer than 1 year to pay off

• Examples of long-term liabilities include student loans, car loans, and home mortgages

• Each payment includes an interest component and some amount that will reduce the initial liability (principal)

• Note that many people use credit cards this way

• This leads to paying more money than originally intended

Net Worth

• Net worth is the difference between your assets and your liabilities

• Figuring your net worth is an easy way to measure your wealth

• You can figure your net worth with a personal balance sheet

• Refer to Figure 4.4 for an example of figuring out your net worth

Figure 4.4

• Lakisha’s car is worth about $6,000 and she still owes $1,200 on it. She has an outstanding credit card balance of $450.

• What is her net worth?

• Solution: Lakisha’s net worth is $6,000 - $1,200 - $450 = $4,350

Changes in the Personal Balance Sheet

• Your Personal Balance Sheet changes as you acquire new assets or liabilities

• This will affect your net worth• There are 2 ways to increase your net worth

1.The value of your assets needs to increase by more than your liabilities

2.To pay down debt on your liabilities

Analysis of Your Personal Balance Sheet

• Lenders look at your personal balance sheet to determine if you can pay the loan

• Loan officers use a debt-to-asset ratio to determine if you have borrowed too much money

• Keep your personal balance sheet in good shape• It can influence the options you have for making

financial decisions and having a good financial plan

• What are the steps in creating a personal balance sheet?

• To see your net worth, you need to identify all your assets, identify all your liabilities, and then subtract your liabilities from you assets.

Budgeting and Your Financial Plan

• Your cash flows feed into your balance sheet• If cash flows exceeds cash outflows, you

will either increase assets or reduce liability • Take a look at figure 4.5 to see how this will

show up on your balance sheet in the form of increased net worth

Figure 4.5

Budgeting and Your Financial Plan

• Budgeting helps in financial planning because it makes you answer the following questions: – How can I improve my net cash flows in the

near term? – How can I improve my net cash flows in the

long term? – What decisions should I make about using

credit, borrowing, and investing?

• What is the importance of budgeting to your financial plan?

• Budgeting helps you evaluate your current financial condition and determine how to improve net cash flows and make wise credit, borrowing, and investment decisions.

Summary

• The budgeting process allows you to monitor and control cash inflows and outflows

• Examine the difference between your forecast and actual cash inflows and outflows

• You can anticipate future problems and make necessary adjustments

Summary

• Your personal balance sheet tells you your financial position at a point in time

• It is a summary of your assets, your liabilities, and your net worth

• Assets can be listed as liquid assets, household assets, and investments

• Liabilities represent the amount of debt you owe• Liabilities can be split into two categories:

– Current liabilities– Long-term liabilities

Summary

• Budgeting can help you manage your cash flows to increase your net worth

• You can use this in building a financial plan

Vocabulary

• Bond• Budget• Current liability• Forecast error• Household asset• Investment• Liability

• Liquid asset• Long-term liability• Market value• Mutual fund• Net worth• Personal balance sheet• Real estate• Stock

Websites

• www.forbes.com • www.kbb.com (Kelley Blue Book)

budgets and balance sheets: your personal financial statements © 2010 pearson education, inc. all...

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