Finance Chapter 1-1-2.pdf

PART 1: FINANCIAL PLANNING Chapter 1 Financial Planning  Why Personal Financial Planning? Easier to spend than to save. Helps achieve financial goals. Allows you to control your finances. © 2007 Prentice Hall Business Publishing Personal Finance: T...

PART 1: FINANCIAL PLANNING Chapter 1 Financial Planning  Why Personal Financial Planning? Easier to spend than to save. Helps achieve financial goals. Allows you to control your finances. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-2  Here’s What You Can Accomplish Manage the unplanned. Accumulate wealth for special expenses. Save for retirement. “Cover your assets.” Invest intelligently. Minimize tax payments. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-3  The Personal Financial Planning Process 5 basic steps to personal financial planning: Evaluate your financial health. Define your financial goals. Develop a plan of action. Implement your plan. Review your progress, reevaluate, and revise your plan. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-4  Personal Financial Planning Process Step 1: Evaluate Your Financial Health Examine your current financial situation. Keep accurate records. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-5  Personal Financial Planning Process Step 2: Define Your Financial Goals Short-term goals. Intermediate-term goals. Long-term goals. Goals change over time. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-6  Personal Financial Planning Process Step 3: Develop a Plan of Action Flexibility Protection Liquidity Minimizing Taxes © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-7  Personal Financial Planning Process Step 4: Implement Your Plan Stick to it. Your financial plan is the tool used to achieve goals. Keep goals in mind and work towards them. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-8  Personal Financial Planning Process Step 5: Review Your Progress, Reevaluate, and Revise Your Plan Review progress and be prepared to formulate a different plan. No plan is fixed. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-9  Establishing Your Financial Goals Financial Goals Cover 3 Time Horizons: Short-term -- within 1 year. Intermediate-term -- 1 to 10 years. Long-term -- more than 10 years. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-10  Short–Term Goals Accumulate Emergency Funds Equaling 3 Months’ Living Expenses Pay Off Bills and Credit Cards. Purchase Insurance. Purchase a Major Item. Finance a Vacation or Entertainment Item. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-11  Intermediate-Term Goals Save for oldest Child’s College. Save for a Down Payment or a Major Home Improvement. Pay Off Major Debt. Finance Large Items (Weddings). Purchase a Vacation Home. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-12  Long-Term Goals Save for Younger Child’s College. Purchase Retirement Home. Create a Retirement Fund to Maintain Current Standard of Living. Take Care of Elderly Family Members. Start a Business. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-13  Stage 1 The Early Years—A Time of Wealth Accumulation Prior to age 54: Purchase a home. Develop a regular Prepare for child pattern of saving. rearing costs. Start retirement Save for a child’s savings. education. Establish an emergency fund. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-14  Stage 2 Approaching Retirement—The Golden Years Transition years Unplanned events have between ages 55-64. dramatic effects on your goals. Retirement goals are very important. Continuously review your financial decisions, insurance protection and estate planning. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-15  Stage 3 The Retirement Years After age 65, live Review insurance, off savings. consider extended nursing home Retirement age protection. depends on savings. Less risky Estate planning investment strategy. decisions are critical. Preserving rather Trim estate tax bills, have wills, living wills, than creating and health proxies. wealth. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-16  Thinking About Your Career Choosing a Major and a Career. Getting a Job. Making it a Successful Career. You’ll work for at least 3 different companies, have over 10 different jobs. Job security is a thing of the past. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-17  Being Successful in Your Career Have a marketable Gain visibility. skill, be well educated, and keep up Take new assignments. with technology. Acquire new skills. Do good work. Develop a strong Project the right network. image. Be ethical. Understand and work within the power structure. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-18  What Determines Your Income? Specialized skills received higher pay. Education is key determinant of salary.* Advanced degrees earn $72,824. Bachelor’s degrees earn $51,194. High school graduates earn $27,280. Non-graduates earn $18,826. *US Census Bureau 2002 © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-19  Fifteen Principles of Personal Finance They form the foundation of personal finance. They will provide you with: an excellent grasp of your own personal finance. a better chance of attaining wealth and achieving financial goals. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-20  Principle 1: The Risk–Return Trade-Off Savings allow for more future purchases. Borrowers pay for using your savings. Investors demand a minimum return to delay consumption - above anticipated inflation. Investors demand higher return for added risk. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-21  Principle 2: The Time Value of Money Money has a time value. Money received today is worth more than money received in the future. Compound interest - interest paid on interest. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-22  Principle 3: Diversification Reduces Risk “Don’t put all your Diversification reduces eggs in one basket.” risk without affecting expected return. To diversify, place Won’t experience money in several great returns or great investments, not just losses—receive an one. average return. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-23  Principle 4: All Risk Is Not Equal Some risk cannot be diversified away. If stocks move in opposite directions, combining them can eliminate variability. If stocks move in same direction, not all variability can be diversified away. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-24  Principle 5: The Curse of Competitive Investment Markets In efficient markets, information is instantly reflected in prices. Cannot earn higher than expected profits from public information. Difficult to “beat the market” -- “bargains” don’t remain so for very long. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-25  Principle 6: Taxes Affect Personal Finance Decisions Taxes influence the realized return of investments. Maximize after-tax return. Compare investment alternatives on an after-tax basis. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-26  Principle 7: Stuff Happens, or the Importance of Liquidity Have funds available for the unexpected. Without liquid funds: Long-term investments must be liquidated. Results in lower price, tax consequences, or missed opportunities. With nothing to sell: Pay higher interest to borrow money quickly. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-27  Principle 8: Nothing Happens Without a Plan People spend money without thinking, but you can’t save without thinking about it. Saving must be planned. Start off with a modest, uncomplicated plan. Later modify and expand your plan. Remember - financial plans cannot be postponed. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-28  Principle 9: The Best Protection Is Knowledge Take responsibility for your financial affairs: Protect yourself from incompetent advisors. Take advantage of changes in the economy and interest rates. Understand personal finance then apply it. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-29  Principle 10: Protect Yourself Against Major Catastrophes Have the right insurance before a tragedy occurs. Know your policy coverage. Insurance focus should be on major catastrophes which can be financially devastating. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-30  Principle 11: The Time Dimension of Investing Take more risk on long-term investments. Large-company stock prices up 10.4% annually over the past 78 years. 20 year-olds investing retirement money will likely earn more in the stock market than other investment alternatives. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-31  Principle 12: The Agency Problem—Beware of the Sales Pitch The agency problem - those who act as your agent may actually act in their own interests. Insurance salespeople, financial advisors, and stockbrokers receive commissions, so select them carefully. Find an advisor who fits your needs, is ethical and effective. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-32  Principle 13: Pay Yourself First For most people, savings are residual. Spend what you like, save what is left. Pay yourself first so what you spend becomes the residual. Reinforce the importance of long-term goals, ensuring goals get funded. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-33  Principle 14: Money Isn’t Everything Extend financial plans to achieve future goals. See more than just $$$ - know what is important in life. Money doesn’t bring happiness, but facing expenses without the funding brings on anxiety. © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-34  Principle 15: Just Do It! Making the commitment to get started is difficult, but the following steps will be easier. One of your investment allies – TIME - is stronger now than it ever will be. Take investment action now — just do it! © 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown 1-35 Chapter 1 Overview of a Financial Plan Copyright ©2004 Pearson Education, Inc. All rights reserved. Chapter Objectives Introduce the subject of personal finance Identify the key components of a financial plan Outline the steps involved in developing your financial plan Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-2 Definitions Personal finance: the process of planning your spending, financing, and investing so as to optimize your financial situation Personal financial plan: a plan that specifies your financial goals and describes the spending, financing, and investing plans that are intended to achieve those goals Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-3 Definitions Opportunity cost: what you give up as a result of a decision Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-4 How You Benefit From An Understanding of Personal Finance Make your own financial decisions – Every spending decision has an opportunity cost Judge the advice of financial advisors – Make informed decisions Become a financial advisor – Many career opportunities available Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-5 Components of a Financial Plan Budgeting and tax planning Managing your liquidity Financing your large purchases Protecting your assets and income (insurance) Investing your money Planning your retirement and estate Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-6 A Plan for Your Budgeting and Tax Planning Budget planning: The process of forecasting future expenses and savings Evaluate your current financial position – Assets: what you own – Liabilities: what you owe – Net worth: the value of what you own minus the value of what you owe Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-7 Budgeting and Tax Planning Exhibit 1.1: How a Budget Affects Savings Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-8 A Plan to Manage Your Liquidity Liquidity: access to funds to cover any short-term cash deficiencies Money management: decisions regarding how much money to retain in a liquid form and how to allocate the funds among short-term investment instruments Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-9 A Plan to Manage Your Liquidity Credit management: decisions regarding how much credit to obtain to support your spending and which sources of credit to use Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-10  Managing Your Liquidity Exhibit 1.2: Managing Your Liquidity Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-11 A Plan for Your Financing Loans often needed for large expenditures – College tuition, car, house Managing loans – How much can you afford to borrow? – Determining maturity of the loan – Selecting a loan with a competitive interest rate Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-12  Financing Your Large Purchases Exhibit 1.3: Financing Process Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-13 A Plan for Your Investing Funds not needed for liquidity can be invested – Stocks, bonds, mutual funds, real estate All investments have some level of risk Risk: uncertainty surrounding the potential return on an investment Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-14 A Plan for Your Retirement and Estate This includes insurance planning, retirement planning, and estate planning – Retirement planning: determining how much money should be set aside each year for retirement and how those funds should be invested – Estate planning: determining how your wealth will be distributed before or upon your death Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-15 Components of Your Financial Plan Exhibit 1.4: Components of Your Financial Plan Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-16 How the Text Organization Relates to the Financial Plan’s Components Each of the six parts of the text covers one specific component of the financial plan An effective financial plan enhances net worth and builds wealth Follow the steps to a complete financial plan at the end of the school term Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-17 How the Text Organization Relates to the Financial Plan’s Components How the components relate to your cash flows – Cash inflows are cash that you receive – Cash outflows are cash that you spend – Budgeting balances income and spending – Liquidity deals with cash excesses or shortages Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-18 How the Text Organization Relates to the Financial Plan’s Components – Financing focuses on obtaining cash for large purchases or repaying loans – Protect assets and income by using cash for insurance and retirement – Investing uses cash to build wealth Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-19 How Financial Planning Relates to Cash Flow Exhibit 1.6: How Financial Planning Affects Your Cash Flows Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-20 Developing the Financial Plan Step 1. Establish Your Financial Goals – Types of goals Car, home, college, wealth, charity – Set realistic goals Stronger likelihood of reaching goals – Timing of goals Short term (within one year) Intermediate (between 1–5 years) Long term (beyond five years) Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-21 Developing the Financial Plan Step 2. Consider Your Current Financial Position – How your future financial position is tied to your education Consider your skills, interests, and career paths – How your future financial position is tied to your career choice Choose a career that will be enjoyable and suit your skills Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-22 Developing the Financial Plan Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-23 Developing the Financial Plan Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-24 Developing the Financial Plan Step 3. Identify and Evaluate Alternative Plans That Could Achieve Your Goals – Plans could be conservative or aggressive Step 4. Select and Implement the Best Plan for Achieving Your Goals – The Internet has valuable financial planning information Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-25 Developing the Financial Plan Focus on Ethics: Personal Financial Advice – Your objective is to get the best advice appropriate to your needs – Be wary of unethical behavior Difficult to discern – Be wary of incompetent advice Be alert, ask questions, carefully consider advice Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-26 Developing the Financial Plan Step 5. Evaluate Your Financial Plan – Keep plan in an accessible place and monitor your progress Step 6. Revise Your Financial Plan – Change plan as financial condition and financial goals change Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-27 How the Internet Facilitates Financial Planning The Internet provides information on all aspects of financial planning – Bank deposit rates – Prices of cars and homes – Financing rates – Prices of investments – Insurance premiums Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-28 How the Internet Facilitates Financial Planning Provides updated information on all parts of your financial plan – Current tax rates and regulations – Investment performances – Online calculators Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-29 How the Internet Facilitates Financial Planning 1.1 Financial Planning Online: Should You Pursue a Career in Financial Planning? Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-30 Financial Planning Online: Financial Planning Tools for You Go to http://finance.yahoo.com This website provides much information and many tools that can be used for all aspects of financial planning. It also provides information for creating retirement plans and wills. Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-31 Integrating Key Concepts Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-32 Looking Ahead Part 1: Financial Planning Tools – Chapter 1 showed an overview of a financial plan – Chapter 2 teaches personal financial statements – Chapter 3 teaches time value of money – Chapter 4 teaches tax planning Part 2: Liquidity Management Part 3: Financing Part 4: Protecting Your Wealth Part 5: Investing Part 6: Retirement and Estate Planning Copyright ©2004 Pearson Education, Inc. All rights reserved. 1-33 Chapter 2 Planning with Personal Financial Statements Copyright ©2004 Pearson Education, Inc. All rights reserved. Chapter Objectives Explain how to create your personal cash flow statement Identify the factors that affect your cash flows Show how to create a budget based on your forecasted cash flows Describe how to create your personal balance sheet Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-2 Chapter Objectives Explain how your net cash flows are related to your personal balance sheet (and therefore affect your wealth) Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-3 Personal Cash Flow Statement Personal cash flow statement: a financial statement that measures a person’s cash inflows and outflows Cash inflows include salaries, interest, dividends Cash outflows include all expenses, both large and small Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-4 Personal Cash Flow Statement Create a statement by recording your revenues and expenses over a period of time Net cash flows: cash inflows minus cash outflows Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-5 Personal Cash Flow Statement Last Month Cash Inflows Actual Disposable income $2,500 Interest on deposits $0 Dividend payments $0 Total Cash Inflows $2,500 Cash Outflows Rent $600 Cable TV $50 Electricity & water $60 Telephone $60 Groceries $300 Health ins & expenses $130 Clothing $100 Car expenses $200 Recreation $600 Total Cash Outflows $2,100 Net Cash Flows $400 Exhibit 2.1: Personal Cash Flow Statement for Stephanie Spratt Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-6 Factors That Affect Cash Flow Factors affecting cash inflows: – Stage in your career path Closely related to your stage in the life cycle — college, career, retirement – Type of job Based on skill level and demand for those skills – Number of income earners in your household Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-7 Factors That Affect Cash Flow Factors affecting cash outflows: – Size of family – Age – Personal consumption behavior Some people spend all of their income and more while others spend mainly on necessities and concentrate on saving for the future Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-8 Creating a Budget Budget: a cash flow statement that is based on forecasted cash flows for a future time period Budgets are useful for anticipating either cash surpluses or cash deficiencies Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-9 Creating a Budget Last This Month Month Cash Inflows Actual Expected Disposable income $2,500 $2,500 Interest on deposits $0 $0 Dividend payments $0 $0 Total Cash Inflows $2,500 $2,500 Cash Outflows Rent $600 $600 Cable TV $50 $50 Electricity & water $60 $60 Telephone $60 $60 Groceries $300 $300 Health ins & expenses $130 $430 Clothing $100 $100 Car expenses $200 $500 Recreation $600 $600 Total Cash Outflows $2,100 $2,700 Net Cash Flows $400 ($200) Exhibit 2.3: Stephanie Spratt’s Revised Personal Cash Flow Statement Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-10 Creating a Budget Anticipating cash shortages – Small shortages can usually be made up from your checking account – Budgets provide warning of shortages so that you can prepare for them Assessing the accuracy of the budget – Compare predicted cash flows to actual cash flows – Adjustment may be necessary Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-11 Creating a Budget Disposable income $2,500 $2,500 $2,500 $0 Interest on deposits $0 $0 $0 $0 Dividend payments $0 $0 $0 $0 Total Cash Inflows $2,500 $2,500 $2,500 $0 Cash Outflows Rent $600 $600 $600 $0 Cable TV $50 $50 $50 $0 Electricity & water $60 $60 $60 $0 Telephone $60 $60 $60 $0 Groceries $300 $300 $280 $20 Health ins & expenses $130 $430 $430 $0 Clothing $100 $100 $170 ($70) Car expenses $200 $500 $500 $0 Recreation $600 $600 $650 ($50) Total Cash Outflows $2,100 $2,700 $2,800 ($100) Net Cash Flows $400 ($200) ($300) ($100) Exhibit 2.5: Comparison of Stephanie Spratt’s Budgeted and Actual Cash Flow for This Month Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-12 Creating a Budget Forecast net cash flows over several months – Use the information for a typical month and adjust it for unusual expenses such as seasonal shopping – Allow for some unexpected expenses like medical care, car and home maintenance Create an annual budget by extending your budget out for longer periods Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-13  Creating a Budget This Yrs Cash Last This This Flow Month Month Month Forecasting Typical (typical x Cash Inflows Actual Expected Actual Error Month 12) Disposable income $2,500 $2,500 $2,500 $0 $2,500 $30,000 Interest on deposits $0 $0 $0 $0 $0 $0 Dividend payments $0 $0 $0 $0 $0 $0 Total Cash Inflows $2,500 $2,500 $2,500 $0 $2,500 $30,000 Cash Outflows Rent $600 $600 $600 $0 $600 $7,200 Cable TV $50 $50 $50 $0 $50 $600 Electricity & water $60 $60 $60 $0 $60 $720 Telephone $60 $60 $60 $0 $60 $720 Groceries $300 $300 $280 $20 $300 $3,600 Health ins & expenses $130 $430 $430 $0 $130 $1,560 Clothing $100 $100 $170 ($70) $100 $1,200 Car expenses $200 $500 $500 $0 $200 $2,400 Recreation $600 $600 $650 ($50) $600 $7,200 Total Cash Outflows $2,100 $2,700 $2,800 ($100) $2,100 $25,200 Net Cash Flows $400 ($200) ($300) $100 $400 $4,800 Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-14 Creating a Budget Improve the budget – Periodically review the budget to see if you are progressing toward your goals – Look for areas that can be changed to improve the budget over time Focus on ethics – Don’t become overly dependent on others – Create a budget and stay within it Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-15 Financial Planning Online: Budgeting Tips Go to: http://dallasfed.org/htm/wealth/index.html Click on: Budget to Save This Web site provides tips on effective budgeting based on your goals. Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-16 Personal Balance Sheet Personal balance sheet: a summary of your assets (what you own), your liabilities (what you owe), and your net worth (assets minus liabilities) A balance sheet reflects your financial position at a specific point in time Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-17 Personal Balance Sheet Assets – Liquid assets are financial assets that can be easily sold without a loss in value – Household assets are items normally owned by a household, such as a home, a car, and furniture You need to establish market values for these assets — the amount you would receive if you sold the asset today Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-18 Personal Balance Sheet – Investments Bonds: certificates issued by borrower, usually firms and government agencies, to raise funds Stocks: certificates representing partial ownership in a firm Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-19 Personal Balance Sheet Mutual funds: investment companies that sell shares and invest the proceeds in investment instruments Real estate: holdings in rental property and land Rental property: housing or commercial property that is rented out to others Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-20 Personal Balance Sheet Liabilities – Current liabilities: debts that will be paid within a year – Long-term liabilities: debts that will be paid over a period longer than one year Net worth is the difference between the value of your assets and the value of your liabilities Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-21 Personal Balance Sheet Creating a personal balance sheet – Allows you to determine your net worth – Update it periodically to monitor changes in your net worth over time Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-22 Personal Balance Sheet Present Situation Assets Liquid Assets Cash 500 Checking Acct 3500 Savings Acct 0 Total liquid assets 4000 Household Assets Home 0 Car 1000 Furniture 1000 Total household assets 2000 Investment Assets Stocks 3000 Total investment assets 3000 Total Assets 9000 Liabilities and Net Worth Current Liabilities Credit card balance 2000 Total current liabilities 2000 Long-Term Liabilities Mortgage 0 Car loan 0 Total long-term liabilities 0 Total Liabilities 2000 Net Worth 7000 Exhibit 2.7: Stephanie’s Spratt’s Personal Balance Sheet Personal Balance Sheet Changes in the personal balance sheet – Some changes will affect both your personal balance sheet and your net worth – Other changes will affect you personal balance sheet and leave your net worth unchanged Consider the previous personal balance sheet with the purchase of a new car… Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-24 Financial Planning Online: The Impact of Reduced Spending Go to: http://www.financenter.com/products/ sellingtools/calculators/budget Click on: “What’s it worth to reduce my spending?” This Web site provides an estimate of the savings you can accumulate by reducing spending. Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-25 Personal Balance Sheet Present Situation With New Car Assets Liquid Assets Cash 500 500 Checking Acct 3500 500 Savings Acct 0 0 Total liquid assets 4000 1000 Household Assets Home 0 0 Car 1000 20000 Furniture 1000 1000 Total household assets 2000 21000 Investment Assets Stocks 3000 3000 Total investment assets 3000 3000 Total Assets 9000 25000 Liabilities and Net Worth Current Liabilities Credit card balance 2000 2000 Total current liabilities 2000 2000 Long-Term Liabilities Mortgage 0 0 Car loan 0 16000 Total long-term liabilities 0 16000 Total Liabilities 2000 18000 Net Worth 7000 7000 Exhibit 2.8: Stephanie’s Personal Balance Sheet If She Purchases a New Car Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-26 Personal Balance Sheet Analysis of the personal balance sheet – Allows monitoring of liquidity, debt, and ability to save – Liquidity is measured by the liquidity ratio Liquidity ratio = Liquid assets/Current liabilities From personal balance sheet on previous slide 4,000/2,000 = 2 Higher result = greater liquidity Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-27 Personal Balance Sheet – Debt level is measured by debt-to-asset ratio Debt-to-Asset Ratio = Total liabilities/total assets From personal balance sheet on previous slide 2,000/9,000 = 22.22% Higher ratio = higher debt relative to assets Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-28 Personal Balance Sheet – Savings rate measures savings over the period in comparison to disposable income over the period Savings rate = Savings during the period Disposable income during the period From personal balance sheet on previous slide $400/$2,500 = 16% Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-29 Relationship Between Cash Flows and Wealth Wealth is built by using net cash flows to invest in assets without increasing liabilities Net cash flows can be used to decrease liabilities which will increase net worth Net worth can change even if net cash flows are zero; for example, the value of an asset or investment increases or decreases Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-30 Financial Planning Online: Budgeting Advice Go to: http://www.financenter.com/products/ sellingtools/calculators/budget Click on “How much am I spending?” This Web site provides a means for comparing your actual budget versus your desired budget and shows how you could improve your budget. Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-31  Relationship Between Cash Flows and Wealth Exhibit 2.9: How Net Cash Flows Can Be Used to Increase Net Worth Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-32 How Budgeting Fits within Your Financial Plan The key budgeting decisions for building your financial plan are: – How can I improve my net cash flows in the near future? – How can I improve my net cash flows in the distant future? Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-33 Integrating Key Concepts Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-34 Integrating Key Concepts Part 1: Financial Planning Tools – In Chapter 2 we learned about personal financial statements – Chapter 3 teaches time value of money – Chapter 4 teaches tax planning Part 2: Liquidity Management Part 3: Financing Part 4: Protecting Your Wealth Part 5: Investing Part 6: Retirement and Estate Planning Copyright ©2004 Pearson Education, Inc. All rights reserved. 2-35