Measuring Your Financial Health and Making a Plan

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Chapter 2

• Measuring Your Financial Health and Making a Plan

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Using a Balance Sheet to Measure Your Wealth

• Personal balance sheet the financial Polaroid
• The financial equation calculating net worth or
  equity
• Assets Liabilities Net Worth

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Your Assets What You Own

• Monetary
• Investment
• Retirement plans
• Real estate
• Automobiles and other vehicles
• Personal property
• Other tangible and intangible assets

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Monetary Assets

• Cash or other assets that can be easily converted
  into cash
• These assets provide necessary liquidity in case
  of an emergency.
• Examples cash, checking accounts, savings
  accounts

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Investment Assets

• Assets that are invested for the future
• These assets are used to accumulate wealth to
  satisfy a goal.
• Examples stocks, bonds, mutual funds, cash
  value life insurance

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Retirement Plans

• Investments by you or your employer to save for
  retirement
• Long-term investments that often carry a penalty
  if used before a certain age
• Examples pensions, IRAs, 401(k), 403(b), Keogh,
  or SEP-IRA plans

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Housing / Real Estate

• Tangible asset such as land and a dwelling,
  reported as fair market value
• Represents most of your savings, and normally
  appreciates in value
• Examples primary residence, vacation home,
  rental properties

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Automobiles and Other Vehicles

• Tangible assets that normally must be inspected
  and licensed
• Reported as fair market value, but normally
  depreciate in value
• Examples cars, trucks, motorcycles, and
  recreational vehicles

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Personal Property

• Tangible assets that represent your lifestyle
• Reported as fair market value, but normally
  depreciate in value
• Examples boats, furniture, electronics,
  clothing, jewelry

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Other Assets

• Any other tangible or intangible asset that may
  or may not be of value
• Examples business ownership, collections, money
  owed you

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Your Liabilities What You Owe

• Current
• Long-term

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Current Liabilities

• Current liabilities are liabilities that must be
  paid off within the next year.
• Examples credit cards, current utility bills,
  and short-term loans

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Long-term Liabilities

• Long-term liabilities are liabilities that extend
  beyond one year.
• Examples home mortgage and auto loans

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Your Net Worth A Measure of Your Wealth

• Insolvency do you owe more than you own?
• How age affects net worth guidelines
• Uses of a balance sheet

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Using an Income Statement to Trace Your Money

• Personal income statement the financial motion
  picture
• Cash basis statement based entirely on actual
  cash flow

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Income Where Your Money Comes From

• Sources of income wages, tips, royalties,
  salary, and commissions
• Income is amount earned, not necessarily amount
  received.

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Expenditures Where Your Money Goes

• The two major expenditure categories taxes and
  living expenses
• Fixed expenses Expenses you dont directly
  control e.g., mortgage, rent, cable TV
• Variable expense Expenses you can control
  e.g., food, entertainment, clothing

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Where Does It Go, On Average?

• Taxes, food, housing, medical care
• The more earned, the more spent on education and
  entertainment

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Using Ratios A Financial Thermometer

• Question 1 Do you have adequate liquidity to
  meet emergencies?
• Question 2 Do you have the ability to meet your
  debt obligations?
• Question 3 Are you saving as much as you think
  you are?

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Question 1 Do You Have Adequate Liquidity?

• Ratios to determine whether or not you have
  enough monetary assets (1) to pay for an
  unexpected large expense or (2) to tide you over
  during periods of reduced or eliminated earnings.
• Current ratio
• Months living expenses covered ratio

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Current Ratio

• monetary assets
• current liabilities
• This ratio shows you whether you have enough
  liquid assets to cover expenses currently due.

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Current Ratio Interpretation

• Ratio greater than 2 recommended
• Track the trend and if going down make changes

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Months Living Expenses Covered Ratio

• monetary assets
• months living expenses
• This ratio tells you how many months of living
  expenses you can cover with your present level of
  monetary assets.

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Months Living Expenses Covered Ratio
Interpretation

• The rule of thumb 3 to 6 months of expenses
• Factors that affect the rule of thumb
• Available credit cards or home equity loans
• Potential for higher earnings on less liquid
  accounts
• Stability of income
• Track the trend and if going down make changes.

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Question 2 Can You Meet Your Debt Obligations?

• Ratios to determine whether or not you can meet
  current or long-term debt obligations
• Debt ratio
• Long-term debt coverage ratio

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Debt Ratio

• total liabilities
• total assets
• This ratio tells you whether you could pay off
  all your liabilities if you liquidated all your
  assets.

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Debt Ratio Interpretation

• Represents percentage of assets financed with
  borrowing
• Track the trend ratio should go down with age

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Long-term Debt Coverage Ratio

• total income available for living expenses
• total long-term debt payment
• This ratio tells you how many times you could
  make your debt payments with your current income.

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Long-term Debt Coverage Ratio Interpretation

• Ratio of 2.5 or greater recommended
• Track the trend and if going down make changes
• Consider the inverse the percentage of
  take-home pay needed to repay debt

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Question 3 Are You Saving As Much As You Think?

• Ratio to determine whether you are saving as much
  of your income as you think
• Savings ratio

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Savings Ratio

• income available for savings
• income available for living expenses
• This ratio tells you what proportion of your
  after-tax income is being saved.

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Savings Ratio Interpretation

• U.S. rate typically 3 - 8
• Varies with stage of the financial life cycle and
  goals

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Record Keeping

• The three reasons for accurate record keeping
• Preparing taxes
• Tracking expenses
• Providing information for others to use in the
  event of an emergency

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Record Keeping (contd)

• The two steps of record keeping
• Tracking your personal financial dealings
• Storing your financial records in an accessible
  manner

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Ways to Track Expenditures

• Using checks and credit cards Those expenditures
  leave a paper trail
• Using cash Record expenditures in a notebook or
  ledger
• Generating a monthly income and expense statement
• Using computer programs to track all financial
  transactions
• Learning how and where to keep records

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Personal Income Taxes

• Keep all tax-related receipts and records for 6
  years.
• Always keep accurate tax records in the event of
  an audit.

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A Financial Plan A Plan for the Future

• Evaluate your financial health balance sheet,
  income statement, and ratios.
• Define your financial goals you must know how
  much you can save.
• Develop a plan of action use the income
  statement and a cash budget.
• Implement your plan Just do it!
• Review your progress, reevaluate, and revise your
  plan back to the balance sheet, income
  statement, ratios, and budget.

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A Cash BudgetA Plan for Today

• A plan for controlling cash inflows and outflows
• Purpose To balance income with expenditures AND
  savings

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Putting It All Together Budgeting

• Evaluate your financial health and your financial
  plan
• Develop a cash budget
• Implement a cash budget

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Developing a Cash Budget

• Examine last years total income and adjust for
  the current year.
• Estimate your tax liability.
• Identify all fixed expenditures.
• Identify all variable expenditures.
• Look for ways to reduce your variable expenses.
• Consider the effect of credit payments on future
  income.

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Calculating the Bottom Line
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Implementing a Cash Budget

• Try the budget for one month.
• Adjust the plan or your expenses as necessary to
  maintain the plan.
• Try the envelope system.

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Managing Your Own Affairs Versus Hiring a
Professional

• Your 3 options
• Go it alone, make a plan and have it checked by a
  professional.
• Work with a professional and develop a plan.
• Let the professional do it all.

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Paying Your Financial Planner

• Fee-only planners derive income from charging the
  client for the service provided or for a
  financial plan.
• Commission-based planners derive income from the
  sale of financial products.
• Some planners charge a combination of fees and
  commissions.

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Choosing a Professional Planner

• Pick a competent planner with accreditation(s)
  from a professional organization(s).
• Pick a planner with whom you are comfortable.
• Pick a planner with experience.

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Choosing a Professional Planner (contd)

• Before hiring a planner, ask lots of questions
  about his/her history.
• Call professional organizations to get
  recommendations.

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Summary

• Balance sheet determines net worth based on a
  comparison of assets and liabilities
• Income statement summarizes cash inflows and
  cash outflows
• Financial ratios diagnose your financial health

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Summary (contd)

• Record keeping implement strategies to
  accurately track expenses and maintain necessary
  financial records for the future
• Cash budget provides a plan for achieving your
  goals by balancing cash inflows and outflows
• Financial planners can provide many levels of
  assistance for your planning needs