Altfest_2e_PPT_Chapter_06.pptx

Chapter 6 Cash Flow Planning 1 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill...

Chapter 6 Cash Flow Planning 1 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Chapter Outline  Chapter Goals  Overview  Cash Flow Planning and Current Standard of Living – Reasons for Savings  How to Increase Savings  Formal and Informal Budgeting – Purchasing Power – Emergency Fund – Liquidity Substitutes 2 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Chapter Outline, cont.  Steps in Household Budget – Establish budgeting goals – Decide on the budgeting period – Calculate cash inflows – Project cash outflows – Compute net cash flow – Compare net cash flow with goals and adjust – Review results for reasonableness and finalize the budget – Compare budgeted with actual figures  Financial Ratios  Chapter Summary 3 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Chapter Goals  Understand the role cash flow has in household finance.  Recognize how important cash flow is to PFP.  Become familiar with budgeting techniques.  Develop savings approaches.  Employ financial ratios as an evaluation method. 4 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Overview  Cash flow planning underlies all major household decisions.  Often, weak cash flow arises from poor planning and control of expenditures.  All parts of a financial plan must incorporate cash flow considerations.  In this discussion we focus on current operating needs. 5 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Overview, cont.  The chapter’s planning objective consists of three parts: – To recognize the importance of cash flow to achieving goals, – To learn how to identify savings problems, and – To establish what can be done in practical terms to overcome these problems. 6 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Cash Flow Planning and Current Standard of Living  Cash flow planning: The scheduling of current and future cash needs to achieve household goals.  Examples of cash flow planning objectives: – Supporting a current life style. – Paying off credit card debt. – Saving for a vacation.  More sophisticated and long-term goals include reducing tax liabilities and planning for retirement. 7 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Cash Flow Planning and Current Standard of Living, cont.  Life styles vary significantly: – Some people live simply. – For others, identities and goals require spending on visible signs of achievement and status.  We have a choice between spending and saving. – To spend is to add to our standard of living today. – To save is to provide for future needs.  While most have no difficulty spending, many have difficulties in generating the amount of savings they require. 8 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Reasons for Savings  Let’s consider eight motives for savings: 1. The Pure Life Cycle Motive: To provide monies to even out differences in earnings over time. 2. The Investment Motive: To take advantage of investment opportunities that can make achievement of our financial goals easier. 3. Downpayment Motive: To provide monies for the down payment or full purchase of longer-lived assets such as durable goods or educational expenditures. 4. Precautionary Motive: To provide a fund to cover future uncertainties such as fluctuating income, sickness, inflationary effects on expenditures, etc. 9 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Reasons for Savings, cont. 5. Improvement Motive: To sacrifice today so that your future lifestyle can improve. 6. Independence Motive: To fund sufficient money to be able to be financially independent after working to a certain age. 7. Bequest Motive: To accommodate funds to provide for nonhousehold members whether they are children, friends, relatives, or charities. 8. Hoarding Motive: The ability to accumulate investments with no intention of converting them into purchases in the future. 10 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Reasons for Savings, cont.  People may intend to save but find themselves with no money left at the end of the pay period.  We next consider several ways of overcoming this problem. 11 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Simple Structural Approach  Treat savings as another expense. Write a check to savings each period at the same time that fixed monthly expenditures are paid.  Alternatively, have cash automatically wired to a separate savings or investment account when the payroll check is deposited.  Develop a budget – a detailed list of income and expenses with planned expenditures limited to accommodate a desired amount of savings. 12 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Provide Motivation: “The Buckets Approach”  People find it easier to save when they have a concrete goal in mind.  Therefore, a slush fund for total savings is not as effective as separate accounts (“buckets”) for each need.  For example: – A bucket for retirement – A bucket for children’s college education – A bucket for a down payment on a house. 13 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Eliminate the Option to Spend  Place money in accounts that have penalties for early withdrawals such as pension accounts, tax deferred annuities, or life insurance policies.  Alternatively, contract for a house and undertake large monthly mortgage payments.  Aside from potential appreciation on the home, the savings will come from accelerated pay-down of debt, which leads to increased equity in the house. 14 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Reduce Temptation  Stay away from stores that result in greater spending than needed.  Carry credit cards only for planned expenditures and for vacations.  Try to use cash as much as possible. 15 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Minimize Discomfort  Some are reluctant to cut back on current spending because they perceive it as resulting in a decline in their standard of living.  They are more agreeable to savings based on future increases in income.  Therefore, success in saving can occur by having people save a fraction of the extra money obtained from raises before the new money enters the spending stream. 16 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Other Reasons for Not Saving  People may fail to save because: – They do not have a strong ability to visualize the long-term future or to estimate future revenues or current savings needs correctly. – They prefer greater spending today rather than in the future. – They feel that their life span is uncertain and, therefore, assured spending today provides more pleasure. – They value simpler, less costly pleasures when they retire and want more material ones now. 17 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Formal and Informal Budgeting  Budgeting: A method of planning current and future household cash flows to determine needs and adhere to desirable allocations of resources.  There are two types of budgeting techniques: Informal budgeting  Involves less detailed ways of planning, sometimes as simple as just thinking about household down payment on a car. Formal budgeting  When budgeting is formal and reflects all categories of household expenditures, usually in the form of a document, it is said to be a household budget. 18 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Formal and Informal Budgeting, cont.  The budget is a type of pro forma cash flow statement with a purpose.  Because little can be done about fixed expenses, budgeting tends to focus on discretionary items.  In theory, saving is a mechanical process.  In reality, human behavior intervenes. We know that many people have trouble saving money.  Detailed written budgets are often a means of establishing structure for those who need it.  The budget becomes a detailed framework for the future. 19 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Purchasing Power  Purchasing power: The amount of goods and services a fixed sum of money will buy.  Purchasing power risk: The risk of having your money decline in what it can buy over time due to inflation.  In making projections of salaries and household costs, inflation must be taken into account.  To be conservative some planners hold salaries level in making projections. This can lead to distortions.  Often, the solution is to express revenues and expenses in current dollar and then, increase these items where appropriate each year by the inflation rate. 20 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Emergency Fund  The ability to turn assets into cash quickly without a high transaction cost or loss of principal is important, as cash flow projections are subject to the risk of unexpected circumstances.  Often, such cash comes from a liquid emergency fund set up specifically for that purpose.  For example: – One may unexpectedly be laid off in our jobs. – One may receive a lower than anticipated bonus. – Costs may rise due to health issues. – Costs may rise due to extensive repairs to the house or car. 21 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Emergency Fund, cont.  The amount placed in an emergency fund depends on the following considerations: – The degree of risk the household faces. – The availability of borrowing alternatives. – Projections of future free cash flow to be generated. – The amount of debt outstanding. – The availability of other assets such as stocks and bonds. 22 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Liquidity Substitutes  Households often desire to place their funds into higher earning assets or can choose to spend a greater sum today.  As an alternative they have liquidity substitutes.  Two types of liquidity substitutes are: – Debt: For shorter term emergencies, cash can be accessed through credit card debt, while larger cash resources needed for extended periods of time can be generated through bank debt. – Marketable securities: Publicly traded financial assets for which a current market value can be determined that are typically easy to sell in order to raise cash. 23 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Steps in Household Budget  The following are the steps required to construct a household budget: – Establish budgeting goals – Decide on the budgeting period – Calculate cash inflows – Project cash outflows – Compute net cash flow – Compare net cash flow with goals and adjust – Review results for reasonableness and finalize the budget – Compare budgeted with actual figures  Let’s consider each in turn. 24 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Establish Budgeting Goals  Immediate goals when establishing a budget may include: – Targeting savings for a particular expenditure – Saving for larger investment purpose  However, a budget may be established because the household is in a negative cash flow situation and debt is accumulating. The goal then is to reverse the cash drain and repay the debt. 25 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Establish Budgeting Goals cont.  The objective of the budget is to: – Assure that the household generates enough cash to meet household operating needs and over time – To provide resources for emergency funds if current assets are insufficient.  By providing hard numbers to household members, the budget can also help to reduce inefficient spending. 26 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Decide on the Budgeting Period  Budgets can be weekly, bi-monthly, monthly or annually.  The period can follow the natural income and spending cycle which can be linked to how often a paycheck is received and when bills are paid.  Many people pay bills on a monthly basis. For review purposes, this period of time represents a balance between too frequent and too little examination of actual versus intended results. 27 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Calculate Cash Inflows  Cash inflows for budgetary purposes are typically the amounts received from paychecks.  Monies received from investments and nonrecurring sources should be displayed in a separate section or otherwise noted.  Cash from investments is for a separate purpose and including nonrecurring inflows can distort the figures.  To simplify matters after-tax inflows received from pay checks are often used. 28 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Project Cash Outflows  Outflows should be separated into nondiscretionary and discretionary items.  Checkbook status or software should be used as a guide for past figures whenever possible.  When that is not possible, a significant miscellaneous category should be used for projections for unanticipated expenses including those for unforeseen circumstances. 29 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Project Cash Outflows, cont.  Table 6.1 Average Annual Household Expenditures 30 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Compute Net Cash Flow  Net cash flow is simply projected cash inflows minus projected cash outflows.  If investment income and nonrecurring items have not been separated yet, adjustments should be made to get a fairer comparison.  The resultant figure should be net cash flow after adjustments, the amount that truly represents your cash generated during the period. 31 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Compare Net Cash Flow with Goals and Adjust  Projected cash flow figures should be compared with goals.  When the figures show a shortfall, determine how the shortfall is to be eliminated.  Three ways to eliminate a shortfall: – Find additional income. – Cut back costs. – Alteration in goals. 32 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Review Results for Reasonableness and Finalize the Budget  Assess the reasonableness of projections. – Do they seem realistic? – Do they take into account inevitable nonrecurring expenses?  The outcome may be an adjustment in projections and in some instances further cutbacks in expenses.  At this point the budget can be finalized. 33 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Compare Budgeted with Actual Figures  Results seldom come out exactly as projected.  Where there are differences the reasons have to be ascertained.  Four common reasons for differences are: – Impulse purchases, – Income that differs from projections, – Unusual occurrences, and – Gifts.  The insights developed as a result of this step should be incorporated in future projections. 34 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Financial Ratios  Financial ratios are a way of gauging the current state of the household’s assets and operating activities.  Frequently, figures from both the balance sheet and cash flow statement are used to develop the ratios.  Comparisons are made with absolute standards of good performance and with relative results for that particular household over time.  We now take a closer look at selected liquidity ratios and operating ratios. 35 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Current Ratios Currents Assets Current Ratio Current Liabilities  The current ratio measures your present resources available to pay current debts.  This ratio should exceed 1.0 x.  Having less could represent an inability to pay debts when due.  The ability to borrow money through credit card purchases and to delay payment on existing card debt has somewhat reduced this concern. 36 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Emergency Fund Ratios Liquid Assets Emergency Fund Ratio Total Monthly Household Expenses  The emergency fund ratio measures how many months of living expenses can be supported by available liquid assets.  Often a ratio of at least 3x is called for signifying that 3 months of cash or other liquid, less volatile securities are available.  The greater the uncertainty for income and expenses, the higher the ratio. 37 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Operating Ratios  Operating ratios measure the overall costs of the household and its components as a percent of total income. Total Nondiscretionary Costs Nondiscretionary Cost Percentage Total Income Total Discretionary Costs Discretionary Cost Percentage Total Income 38 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Operating Ratios, cont.  Nondiscretionary cost percentage provides the proportion of day-to-day overhead costs to total revenues.  Our goal is to reduce the nondiscretionary percentage over time  The lower the percentage, the greater the amount available for discretionary costs and savings and investment. Discretionary costs represent the benefits of our household efforts.  Assuming appropriate savings, the lower the percentage of household fixed costs and the higher the percentage of optionable expenses, the greater 39 your satisfaction and standard of living. Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Operating Ratios, cont. Total Nondiscretionary Total Discretionary Costs Costs Total Operating Percentage Total Income  The total operating cost percentage indicates how much of household revenues are being spent today on nondiscretionary and discretionary costs.  It can serve as a control on expenses and as a guide to the amount available for capital expenditures and savings.  The lower the percentage, the larger the amount 40 available for these items Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Payout Ratio Discretionary Discretionary Capital Expenses Expenditures Discretionary Payout Percentage Cash Flow before Discretionary Expenses  Cash flows before discretionary expenses measures the percentage of available cash flow that is actually expended on all leisure outlays.  A high payout percentage can reflect a desire for a higher standard of living today as opposed to improved household efficiencies and a higher, more secure standard of living in the future. 41 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Savings Percentage Net Cash Flow Targeted Savings Change in Debt Gross Savings Percentage Total Income  The savings percentage indicates the total combined percentage of total income that is being put away for future needs.  The amount expended to pay off debt is considered savings while an increase in debt reduces the savings rate. 42 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Chapter Summary  Cash flow planning is often performed near the beginning of the financial planning process.  Available cash flow allows financial planning.  Savings for future needs can be difficult for some and budgeting techniques can help bring about acceptable savings rates.  There are a variety of methods that can facilitate savings including a simple structural approach providing motivation, eliminating an option to spend, reducing temptation, and minimizing discomfort.  Financial ratios can provide an objective assessment of 43 specific segments of a household’s financial condition. Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.