Afince 1 chapter 2 measuring your financial health and making a plan part 1 PDF

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an example for the course. please read it a lot and understand the context well. thank you!...

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SCHOOL OF BUSINESS ADMINISTRATION AND ACCOUNTANCY

AFINCE 1

Prepared by: BELEN B. APOSTOL, MBA

PERSONAL FINANCE

A Self-regulated Learning Module

CHAPTER 2- MEASURING YOUR FINANCIAL HEALTH AND MAKING A PLAN OBJECTIVES OF THE LESSON: 1. Calculate the level of net worth or wealth using a balance sheet. 2. Analyze where money comes from and where it goes using an income statement. 3. Use ratios to identify financial strengths and weaknesses. 4. Set up a record-keeping system to track income and expenditures. 5. Implement a financial plan or budget that will provide for the level of savings needed to achieve goals. 6. Identify how to decide if a professional financial planner will play a role in financial affairs. Measuring your Financial Health and Making a Plan Plan. If you’re like most people, you can probably spend money without thinking about it, but you can’t save money without thinking about it. Saving isn’t a natural event. It must be planned. Planning and budgeting require control—they don’t come naturally. Without the ability to measure our financial health and develop a plan and budget, we will not achieve our financial goals. Showing financial restraint isn’t as much fun as spending with reckless abandon, but it’s a lot more fun than winding up broke and homeless. Making and sticking with a plan isn’t necessarily easy, and it often involves what some people would consider sacrifices, such as getting a job during vacations or simply skipping a designer coffee or milk tea. The fact is, though, that the rewards of taking financial control are worth any small sacrifices and more. In this chapter we begin the budgeting and planning process that was first outlined in Figure 1.1, specifically, working on Steps 1 and 3 as shown in Figure 2.1. We begin by measuring our wealth using a personal balance sheet and then a personal income statement to help figure out where our money came from and where it went. With this information in hand, we will use ratios to check into the status of our financial health and look at ways to keep track of all this. Finally, we will set up and implement a cash budget.

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Using a Balance Sheet to Measure Your Wealth Before you can decide how much you need to save to reach your goals, you have to measure your financial condition—what you own and what you owe. Corporations use a balance sheet for this purpose, and so can you. A personal balance sheet is a statement of your financial position on a given date—a snapshot of your financial status at a particular point in time. It lists the assets you own, the debt or liabilities you’ve incurred, and your general level of wealth, which is your net worth or equity. Assets represent what you own. Liabilities represent your debt or what you owe. To determine your level of wealth or net worth, you subtract your level of debt or borrowing from your assets. Figure 2.2 is a sample balance sheet worksheet. We will now look at each section.

Assets: What You Own The first section of the balance sheet represents your assets. All your possessions are considered assets whether or not you still owe money on them. When you estimate the value of all your assets, list them using their fair market value, not what they cost or what they will be worth a year from now. The fair market value can be more or less than the price you paid for a given asset, depending on what others are willing to pay for that asset now. Remember, a balance sheet is a snapshot in time, so all values must be current. Monetary Assets There are a number of different types of assets. The first type of asset listed on the balance sheet is a monetary asset. A monetary asset is basically a liquid asset—one that is either cash or can easily be turned into cash with little or no loss in value. Monetary assets include the cash you hold, your checking and savings account balances, and your money market funds. These are the cash and cash equivalents you use for everyday life. They also provide the necessary liquidity in case of an emergency.

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Investment The second major category of assets, investments, refers to such financial assets as common stocks, mutual funds, or bonds. In general, the purpose of these assets is to accumulate wealth to satisfy a goal such as buying a house or having sufficient savings for a child’s college tuition or your retirement. Your insurance policy may also be an investment asset if it has a cash surrender value. This type of insurance policy can be terminated before the insured’s death, at which time the policyholder will receive the cash value of the policy. If you have this type of insurance policy, then its cash surrender value should be included as part of your investment assets. Finally, any real estate purchased for investment purposes should also appear as an asset. The common thread among all these assets is that they are not meant for use, as you would use a car or a house. Instead, they have been purchased for the purpose of generating wealth. Retirement Plans These include investments made by you or your employer (if they offer such) aimed directly at achieving your goal of saving for retirement. Housing Your house, if you own it, comprises another asset category. Although a house is an asset that you use—a tangible asset—it usually holds the majority of your savings. The value of your house recorded on the balance sheet should be its fair market value, even though at that price it may take several months for it to sell. Keep in mind that even if you owe money on your home, it’s still yours. Automobiles Your car, truck, motorcycle, or other vehicle also gets its own asset category. Similar to your home, your vehicle is a tangible asset—one you probably use daily. However, unlike your home, your vehicle is likely to be worth less than you paid for it. The fair market value for vehicles almost always goes down, often starting right after you take it home from the showroom. Do not include any cars you lease as assets. If the car is leased, you don’t hold title to it and thus don’t actually own it. Likewise, a company car that you get to use but don’t own wouldn’t count as an asset. Personal Property This category consists of tangible assets. Basically, personal property is all your possessions—furniture, appliances, jewelry, TVs, and so forth. In general, although you may have spent a good deal of money on these items, their fair market value will be only a fraction of the purchase amount. Other Assets The “other” category includes anything that has not yet been accounted for. As an example, you might own part of a business, or you might be owed money by a deadbeat friend. All of these count as assets and must appear at their fair market value on your balance sheet. Of course, if your friend is really a deadbeat, the amount owed shouldn’t appear as an asset—since you’ll never see it! Summed up, these asset categories represent the total value of everything you own. Liabilities: What You Owe A liability is debt that you have taken on and that you must repay in the future. Most financial planners classify liabilities as current or long-term. Current liabilities are those that must be paid off within the next year, and long-term liabilities come due beyond a year’s time. In listing your liabilities, be sure to include only the unpaid balances on those liabilities. Remember, you owe only the unpaid portion of any loan. Current Debt In general, the current debt category is comprised of the total of your unpaid bills including utility bills, past-due rent, cable TV bills, and insurance premiums that you owe. The unpaid balance on your credit cards represents a current liability because it’s a debt that you should pay off within a year. Even if you have not yet received a bill for a purchase you made on credit, the amount you owe on this purchase should be included as a liability. A Self-regulated Learning Module

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Long-Term Debt This category tends to consist of debt on larger assets, such as your home or car. Because of the nature of the assets it finances, long-term debt almost always involves larger amounts than does current debt. If you think about it, the very reason long-term debt covers the long term is that it involves sums too large for the average individual to be able to pay off within 1 year. The largest debt you ever take on, and thus the longest-term debt you ever take on, will probably be the mortgage on your home. Car loans are another major category of long-term debt. Just as a leased car is not considered an asset, the remaining lease obligation should not be considered a liability, or something that you owe. In effect, you are “renting” your car when you lease it. However, it’s a very fine line between a debt obligation and a lease contract—if the lease simply can’t be broken, no matter what, it may be considered debt. Keep in mind that future lease payments, future insurance payments, and future rent payments are something you may owe in the future, but they are not something you owe right now. Finally, any other loans that you have outstanding should be included. For example, loans on your life insurance policy, bank loans, and installment loans are liabilities. Together, long-term debt and current liabilities represent what you owe.

Net Worth: A Measure of Your Wealth To calculate your net worth, subtract your total debt from your total assets. This represents the level of wealth you have accumulated. If your liabilities are greater than the value of your assets, then your net worth has a negative value, and you’re considered insolvent. Insolvency results from consuming more than you take in financially, and in some instances it can lead to bankruptcy. What is a “good” level of net worth? That depends upon your goals and your place in the financial life cycle. You would expect a 25-year-old to have a considerably lower net worth than a 45-year-old. Likewise, a 45year-old who has saved for college for three children may have a higher net worth than a 45-year-old with no children. Which one is in better financial shape? The answer doesn’t necessarily rest on who has the larger net worth, but on who has done a better job of achieving financial goals. Just to give you an idea of where most people stand, Table 2.1 presents the average annual salary and net worth for individuals along with some other financial data. Your goal in financial planning is to manage your net worth or wealth in such a way that your goals are met in a timely fashion. The balance sheet enables you to measure your progress toward these goals, and to monitor your financial well-being. It also allows you to detect changes in your financial well-being that might otherwise go unnoticed and correct them early on.

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Sample Balance Sheet for Larry and Louise Tate To illustrate the construction and use of a balance sheet, we have a sample from Larry and Louise Tate shown in Figure 2.3. Remember, a balance sheet provides a snapshot of an individual’s or a family’s financial worth at a given point in time. As investment values fluctuate daily with the movements in the stock market, so does net worth. The balance sheet in Figure 2.3 was constructed on December 31, 2011, and reflects the value of the Tates’ assets, liabilities, and net worth on that specific date.

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Using an Income Statement to Trace Your Money The second step in creating a personal financial plan is to trace your money. A balance sheet is like a financial snapshot: It tells you how much wealth you have accumulated as of a certain date. An income statement is more like a financial motion picture: It tells you where your money has come from and where it has gone over some period of time. Actually, although it’s generally called an income statement, it’s really an income and expenditure, or net income, statement because it looks at both what you take in and subtracts from that, or “nets out,” what you spend, with what is left over being the amount available for savings or investment. An income statement can help you stay solvent by telling you whether or not you’re earning more than you spend. If you’re spending too much, your income statement shows exactly where your money is going so that you can spot problem areas quickly. Of course, if you don’t have a spending problem, your income statement tells you how much of your income is available for savings and for meeting financial goals. With a good income statement, you’ll never end another month wondering where all of your money went. Personal income statements are prepared on a cash basis, meaning they’re based entirely on actual cash flows. You record income only when you actually receive money, and you record expenditures only when you actually pay money out. Giving someone an IOU wouldn’t appear on an income statement, but receiving a paycheck would. Buying a stereo on credit wouldn’t appear on your income statement, but making a payment to the credit card company would. As a result, a personal income statement truly reflects the pattern of cash flows that the individual or family experiences. To construct an income statement, you need to record your income only for the given time period and subtract from it the expenses you incurred during that period. The result tells you the amount you have available for savings. Figure 2.4 shows a general outline for an income statement.

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Income: Where Your Money Comes From For your income statement, income, or cash inflows, will include such items as wages, salary, bonuses, tips, royalties, and commissions, in addition to any other sources of income you may have. Additional sources of income might include family income, payments from the government (e.g., veterans’ benefits or welfare income), retirement income, investment income, and those yearly checks you get for winning the Sweepstakes. Some of your income may not ever reach your pocketbook. Instead, it may be automatically invested in a voluntary retirement plan, used to pay for insurance you buy through work, or be sent to the government to cover taxes. For example, if your total earnings are $50,000 and you automatically have $4,000 deducted for insurance and a retirement fund, and $8,000 deducted in taxes, then your income would be $50,000 even though your take-home pay is only $38,000. You must make sure to record the full amount of what you earned—your full earnings and taxes paid, not just the dollar value of your paycheck. Any money you receive, even if you automatically spend it (even for taxes), is considered income at the point in time when it is received. Next, include the total amount of money you pay in the government, and Social Security, income taxes. Then, subtract your taxes from your earnings. This is your take-home pay, or the money you have available for expenditures. Expenditures: Where Your Money Goes Although income is usually very easy to calculate, expenditures usually are not. Why? Because many expenditures are cash transactions and do not leave a paper trail. It’s hard to keep track of all the little things you spend your money on. But to create a valuable personal financial plan, you must understand where your money goes. Look at the categories of expenditures in Figure 2.4 to get an idea of the ways living expenses can be categorized and tracked. Some financial planners also classify living expenses as variable or fixed expenditures, depending on whether you have control over the expenditure. These classifications are appealing, but not all expenses fit neatly into them. For example, it’s difficult to categorize car or home repairs as being either variable (you have a choice in spending this money) or fixed (you have no choice in spending this money). They may be postponable but probably not for too long. Where does all our money go? Turns out that what the average household spends its money on depends on how much it earns. The more we earn, the more we spend on such things as education and entertainment. Figure 2.5 provides a breakdown of spending for the average U.S. household or, as the government calls it, consumer unit. It shows that housing is the major expenditure, accounting for 34.4 percent of all expenditures. Under the heading of housing, shelter is the main item, with utilities, fuels, and public services following next in importance. The category that comes in second in terms of money spent is transportation, which accounts for 15.6 percent of all expenditures, followed by food, which accounts for 13 percent of all expenditures. Interestingly, but probably not a surprise, 41.1 percent of food expenditures, or an average of $2,619 per year, is spent away from home at restaurants.

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The median household income is less than the $62,857 shown in Figure 2.5; it’s actually only about $49,777. If you look at what is considered “family households,” it is pretty close to $61,265, and for “non-family households” (someone living alone or unrelated people living together), it is only $30,444. Still, this figure gives you a good idea of what some of the typical expenditures are for a typical household unit. Also, keep in mind that the amounts in Figure 2.5 are spending averages. Preparing an Income Statement: Louise and Larry Tate To get a better understanding of the preparation of an income statement, take a look at the one for Louise and Larry Tate in Figure 2.6. The income statement and balance sheet can and should be used together. The balance sheet lets you judge your financial standing by showing your net worth, and the income statement tells you exactly how your spending and saving habits affect that net worth. If your balance sheet shows you that you’re not building your net worth as much or as quickly as you’d like, or if you’re overspending and actually decreasing your net worth, your income statement can help by showing you where your money is going.

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By reviewing all your expenses and spending patterns, you can decide on specific ways to cut back on purchases and increase savings. This process of setting spending goals is referred to as setting a budget. As you will see later in this chapter, a smart budget includes estimates of all future expenses and helps you manage your money to meet specific financial goals. But before you can design and implement a budget plan, you first need to analyze your balance sheet and income statement using ratios to better understand any financial shortcomings or deficiencies you discover.

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