Transcript Chapter 2 PPP - College of the Canyons

PART 1:
FINANCIAL PLANNING
Chapter 2
Measuring Your
Financial Health and
Making a Plan
Learning Objectives
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Calculate your level of net worth or wealth using a balance
sheet.
Analyze where your money comes from and where it goes using
an income statement.
Use ratios to identify your financial strengths and weaknesses.
Set up a record-keeping system to track your income and
expenditures.
Implement a financial plan or budget that will provide for a level
of savings needed to achieve your goals.
Decide if a professional financial planner will play a role in your
financial affairs.
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Using a Balance Sheet to Measure
Your Wealth
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First Step in a Personal Financial Plan
A personal balance sheet is a statement of your
financial position on a given date.
A snapshot of your financial status at a particular
time.
It lists the assets you own, the debt or liabilities
you’ve incurred, and your general level of wealth,
known as net worth or equity.
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Assets: What You Own
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All of your possessions are considered
assets even if you owe money on them.
Assets are listed using fair market value.
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Assets: What You Own
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Different types of assets:
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Monetary assets – liquid assets including cash,
checking and savings accounts, money market
funds
Investments – common stocks, mutual funds,
bonds
Retirement plans – IRA’s, 401(k) or 403 (b) plans,
Keogh plans, SEP-IRA plans, company pension
plans
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Assets: What You Own
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Different types of assets:
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House
Vehicles
Personal property – furniture, jewelry, TV’s
Other – collectibles, part ownership in a business
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Liabilities: What You Owe
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Liability is debt that must be repaid in the
future.
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Current liabilities must be paid off within the next
year.
Long-term liabilities come due beyond a year.
List only the unpaid balances.
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Liabilities: What You Owe
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Different types of liabilities:
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Current bills – unpaid bills including utility bills,
insurance premiums, credit card balances.
Long-term liabilities – debt on larger assets such
as home, car, or student loan.
Other loans – any other outstanding debt
including installment loans, bank loans.
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Net Worth: A Measure
of Your Wealth
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Net worth = total
assets - total
debt
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If liabilities > assets, then a
negative net worth and
insolvency.
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If liabilities < assets, then a
positive net worth.
Manage your net worth so that
goals are met in a timely
manner.
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Using an Income Statement
to Trace Your Money
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Second Step in a Personal Financial Plan
Trace your money.
Income statement states where your money has
come from and where it has gone over a period of
time.
While the balance sheet was a snapshot, the income
statement is like a movie video.
Personal income statements are on a cash basis,
using actual cash flows.
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Income: Where Your Money
Comes From
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Income or cash inflows:
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Wages, salary, bonuses, tips, commissions
Other sources such as family income, government
payments (veterans benefits, welfare), investment
income.
Some income may be automatically invested for
you towards a retirement plan or insurance plan.
Subtract taxes (federal, state, social security) from
earnings to calculate your take-home pay.
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Expenditures: Where Your
Money Goes
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While income is easy to calculate, spending may not
be.
Cash transactions may not leave a paper trail.
Classify living expenses as either variable or fixed
expenditures.
The average household in 2005 worked 107 days to
pay taxes – 70 days for federal taxes, 37 days for
state and local taxes.
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Using Ratios: Financial
Thermometers
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Third Step in a Personal Financial Plan
Use ratios.
With financial ratios, you analyze raw data in the
balance sheet or income statement then compare it
to targets.
Use ratios to better understand how you are
managing financial resources.
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Using Ratios: Financial
Thermometers
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Use financial ratios to answer these
questions:
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Do I have enough liquidity to meet emergencies?
Can I meet debt obligations?
Am I saving as much as I think I am?
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Question 1: Do I Have Enough
Liquidity to Meet Emergencies?
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Current Ratio =
Monetary Assets
Current Liabilities
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To judge liquidity, compare cash
and other liquid assets with debt.
While financial advisors look for
ratio to be above 2.0, the trend
is most important.
This ratio does not consider
monthly payments towards longterm debt (mortgage, car loans).
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Question 1: Do I Have Enough
Liquidity to Meet Emergencies?
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Month’s Living Expenses
Covered Ratio =
Monetary Assets
Annual Living Exp / 12
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Tells how many months of
living expenses can be
covered with present
monetary assets.
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Liquid assets covering 3-6
months are optimum, less if
credit and insurance
protection.
Liquid investments have low
risk/low return trade-off.
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Question 2: Can I Meet
My Debt Obligations?
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Debt Ratio =
Total Liabilities
Total Assets
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Debt ratio tells you
what percentage of
your assets has been
financed by borrowing.
This ratio should
decrease as you age.
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Question 2: Can I Meet
My Debt Obligations?
Long-term Debt
Coverage Ratio =
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Total Income
Available for Living Exp
Total Long - Term
Liability Payments
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Relates the amount of funds
available for debt repayment
to the size of the debt
payments.
This is the number of times
you could make your debt
payments with your current
income.
Ratio should not be Less
than 2.5
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Question 3: Am I Saving as Much
as I Think I Am?
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Savings Ratio =
Income Available for
Savings & Investments
Income Available for
Living Expenses
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This is the ratio of
income available for
savings and investment
to income available for
living expenses.
It tells you the
proportion of your aftertax income that you are
saving.
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Record Keeping
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Fourth Step in Personal Financial Planning
Keep and maintain records.
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Without records it is difficult to prepare taxes.
Strong record keeping allows you track expenses
and know how much and where you are
spending.
Organized record keeping makes it easier for
someone to step in during an emergency and
understand your financial situation.
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Record Keeping
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Record keeping involves just 2 steps:
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Track your financial dealings.
File and store your financial records so they are
readily accessible.
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Record Keeping
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Credit card and check expenditures are easy
to track, but cash expenditures must be
tracked as they occur.
After tracking, record transactions in a
ledger.
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Putting It All Together: Budgeting
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5-step planning process:
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Evaluate your financial health using the balance sheet and
income statement.
Set financial goals by using the balance sheet and income
statement to set and achieve goals.
Develop a plan of action using the income statement.
Set up a cash budget by using the income statement for
flexibility, liquidity, protection, and minimizing taxes.
Monitor your progress, using the balance sheet and
income statement.
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Developing a Cash Budget
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A budget is a plan for controlling cash
inflows and outflows.
The cash budget keeps income in line with
expenditures and savings and allocates
amounts to different spending categories.
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Developing a Cash Budget
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Preparing a cash budget:
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Begin with the most recent personal income
statement, examine last year’s total income,
make adjustments for the coming year.
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Estimate your taxes.
Calculate your anticipated after-tax income or “take
home pay.”
Estimate your living expenses, identify fixed then
variable expenditures.
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Developing a Cash Budget
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Income Available for
Savings & Investment =
Anticipated Take Home
Pay - Anticipated Living
Expenditures.
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Compare
anticipated
monthly savings
with target
savings.
Remember: No
budget is set in
stone.
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Hiring a Professional
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How to incorporate professionals:
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Do it alone; make your own plan and have it
checked by a professional.
Work with a professional to develop a plan.
Leave it all in the hands of a professional.
The more unique your situation, the greater
the need for professional help.
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Choosing a Professional Planner
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The title “financial planner” is not legally
defined.
Accreditations:
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Personal financial specialist (PFS) is a certified
public accountant
Certified financial planner (CFP)
Chartered financial consultants (ChFh)
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Choosing a Professional Planner
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Ascertain the planner’s credentials
Consider their level of experience
Ask for referrals
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Choosing a Professional Planner
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Fee-Only Planners earn income through fees
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You control the products and commissions
Fee and Commission Planners charge a
commission on products they recommend
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Lower fees if you use their commissioned
products
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Choosing a Professional Planner
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Fee Offset Planners charge a fee but reduce
it by earned commission
Commission Based Planners work on a
commission basis only
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This is the most available type of planner
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