Chapter 2: Financial Planning

Objectives

• Explain the concept of financial planning, its components, and its benefits.

• Describe financial statements, particularly the balance sheet and the income and expense statement.

• Use financial ratios to evaluate your financial strength and progress.

Objectives

• Identify the purposes and methods of financial recordkeeping.

• Describe the use of computer software in personal financial planning.

• Explain how to choose a professional financial planner.

Financial Planning

The process of developing and

implementing a coordinated series of

financial plans to achieve financial

success.

• No clear goals

• Disorganized records

• Lack of economic understanding

• Flawed decision making

Common Financial Behaviors

BEWARE!

• Specified values

• Explicitly stated goals

• Informed economic projections

• Logical and consistent financial strategies

Components of Successful Financial Planning

Economic Data

LivingExpenses

Earnings

Earnings

Earnings

Managerial Effort

PlanningDecision Making

ImplementingControllingEvaluating

Coping and AdaptingFeedback

Communication

ValuesAttitudesLifestyleWantsNeeds

RelationshipsMoneyWealth

AchievementOf FinancialObjectives

Financial PlansFor Spending/Saving

Financial PlansFor Risk Management

Financial PlansFor Capital Accumulation

Input Throughput Output

• Compilation of financial data

• Communicate information

• Indicate financial condition

• Prepares user to read corporate financial statements

Financial Statements

FUNCTIONS PERFORMED:

The Balance Sheet

• Assets – Items owned• Liabilities- Items owed• Net worth– Difference between what

one owns and owes.

VALUE OF EVERYTHING OWNED MINUS EVERYTHING OWED:

Assets- Liabilities = Net Worth

• Monetary or Liquid assets

• Tangible or Household assets

• Investment assets

Assets

• Short-term liabilities – anything that will be paid off in 12 months or less.

• Long-term liabilities—anything that will still have a balance after 12 months.

Liabilities

•Income – How much you made.

•Expenses – How much you spent.

•Net gain or loss—How much you have left.

•Income – Expenses = Net gain or loss

Income - Expense Statement

SUMMARY OF CASH-FLOW TRANSACTIONS OVER TIME:

Incomes

• Salaries or wages

• Bonuses and commissions

• Child support and alimony

• Public assistance

• Social Security and pensions

Incomes

• Scholarships and grants

• Interest and dividends

• Income from the sale of assets

• Other income (gifts, tax refunds, rent, royalties)

Expenses

• Fixed expenses—items that are the same every month (you don’t have control over these).• e.g. house payment, car payment,

insurance premium

• Variable expenses—expense changes based on the way you live (you have control over these).• e.g. meals, utilities, entertainment

Income Statement

INCOME STATEMENT

INCOMEGross Wages 1,000$ Loan from parents 500

1,500$ EXPENSES

Taxes 250 Room rent 500$ Utilities 25 Laundry 15 Food 120 Car Insurance 125 Car loan 150 Medical Insurance 150 Telephone 40 Clothing 25 Entertainment 45 Other -

1,445$

SURPLUS/(DEFICIT) 55$

Assets Liabilities

Monetary (Liquid) Assets Short-term (Current) LiabilitiesCash 1,200$ Dentist bill 120$ Checking account 250 Credit card balance 1,500

Savings account 350 Total short-term (current) liabilities 1,620

Total monetary (liquid) assets 1,800$ Long-term Liabilities

Tangible (Household) Assets Mortgage -$ Home -$ Car loan 2,000

Car 2,500 Total long-term liabilities 2,000$ Furniture 400

Total tangible (household) assets 2,900 Total Liabilities 3,620

Investment Assets Net Worth 2,580$ Stocks 1,500$

Total investment assets 1,500$

Total Assets 6,200$

Balance Sheet

Financial Ratios

• Basic liquidity ratio

• Debt-to-asset ratio

• Debt-service-to-income ratio

• Investment-assets-to-net-worth ratio

OBJECTIVE ASSESSMENTS OF FINANCIAL STATUS:

Basic Liquidity Ratio

This ratio shows that this person could pay their monthly expenses for 1.25 months using monetary assets.

Using the information from the Balance Sheet earlier in this presentation

Basic Liquidity Ratio = Monetary (Liquid) Assets

Monthly Expenses

= $1,800 $1,445

= 1.25

Liquidity Ratio

This ratio shows that this person has $1.11 liquid assets for every $1 of current liabilities.

Using the information from the Balance Sheet earlier in this presentation

Liquidity Ratio = Liquid Assets

Current Liabilities

= $1,800 $1,620

= 1.11

Debt-to-Asset Ratio

Debt-to-Asset Ratio = Total Debt

Total Assets

= $3,620 $6,200

= .58

If your debt is greater than your assets you are technically insolvent.

Debt Service-to-Income Ratio

Debt Service-to-Income Ratio = AnnualDebt

Repayment

Gross Income

= $1,800 $12,000

= .15 or 15%

1

2

1 The Annual Debt Payment for this calculation includes mortgage

2 Annual debt payment in this example is the car loan monthly payment x 12 months ($150 x 12 = $1,800).

A ratio of 36% or less indicates that gross income is adequate to make debt repayments.

Debt Payment-to-Disposable Income Ratio

Debt Payment-to- Disposable Income Ratio =

Monthly nonmortgage debt payments

Disposable income

Disposable income is the amount of take-home pay remaining after all deductions are withheld for taxes.

A ratio greater than 20% is considered problematic.

Investment Assets-to-Net Worth Ratio

Good Debt vs. Bad Debt

Debt incurred for consumption is bad debt.

Bad Debt

= Debt Danger Ratio

Annual Income

Debt Danger Ratio beyond 25% can spell trouble.

Assessing Financial Progress

• Balance sheet

• Income - expense statement

• Financial ratios

• Am I spending, saving, and investing money where I really want to?

Financial Recordkeeping

• Where you are

• Where you have been

• Where you are going

DETERMINE:

Recordkeeping Issues

• Original source records

• Safeguarding/storage of records

• Use of computer software

Professional Financial Planning

• Commission-only

• Fee-only

• Fee-based

• Designations and credentials

Key Words and Concepts

Financial Planning is the process of developing and implementing a coordinated series of financial plans to achieve financial success.

Values are fundamental beliefs about what is important, desirable, and worthwhile.

Financial Goals are the specific long- and short-term objectives to be attained through financial planning and management efforts.

Financial Strategies are preestablished plans of action to be implemented in specific situations.

Financial Statements are compilations of personal financial data designed to communicate information on money matters.

Balance Sheet (or net worth statement) describes an individual’s or family’s financial condition on a specified date.

Income and Expense (or cash flow) Statement lists and summarizes income and expense transactions that have taken place over a specific period of time.

Assets include everything you own that has monetary value.

Liabilities are your debt.

Net Worth is the dollar amount left when what is owed is subtracted from the dollar value of what is owned. Everything should be calculated at fair market value.

Key Words and Concepts (Cont.)

Fair Market Value is the amount a buyer would pay a willing seller.

Monetary Assets (or liquid assets) include cash and near-cash items that can be readily converted to cash.

Tangible (or use) Assets are physical assets that have fairly long lifespans and could be sold to raise cash but whose primary purpose is to provide maintenance of one’s lifestyle.

Investment assets (also known as capital assets) include tangible and intangible items acquired for the monetary benefits they provide.

Diversification of investments means the investor puts money in a variety of investments.

Short-term (or current) Liability is an obligation that will be paid off within one year.

Long-term Liability is an obligation that will be paid off in more than one year.

Insolvent means net worth is negative.

Fixed Expenses are usually paid in the same amount during each time period.

Variable Expenses are expenditures over which and individual has considerable control.

Net Gain/Loss shows the amount of money left after you subtract expenses from income.

Financial Ratios are objective numerical calculations designed to simplify making judgmental assessments of financial strength over time.

Key Words and Concepts (Concl.)

Liquidity is the speed and ease with which an asset can be converted into cash.

Financial Ratios:Basic Liquidity Ratio: monetary (liquid) assets

monetary expenses

Reveals the number of months a family could continue to meets its expenses from monetary assets after a total loss of income. Families should have a basic liquidity ratio of 3.

Debt-to-Asset Ratio: total debt total assetsMeasures the solvency and ability to pay debt

Debt Service-to-Income Ratio: annual debt repayments gross incomeProvides an incisive view of the total debt burden of an individual. A ratio of .36 or less indicates that gross income is adequate to make debt repayments.

Investment Assets-to-Net Worth Ratio: investment assets net worth

Expresses how well an individual is advancing toward their financial goals for capital accumulation. Experts recommend 50% or higher.