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Chapter 3

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Chapter 3

  1. 1. Personal Finance: An Integrated Planning Approach Winger & Frasca Chapter 3 Financial Statements and Budgets
  2. 2. Major Topics <ul><li>The Balance Sheet </li></ul><ul><li>The Income Statement </li></ul><ul><li>Evaluating Past Financial Performance </li></ul><ul><li>Achieving Goals through Budgeting </li></ul>
  3. 3. The Personal Balance Sheet <ul><li>Shows: </li></ul><ul><ul><li>What a Family Owns--Its Assets </li></ul></ul><ul><ul><li>What it Owes--Its Liabilities </li></ul></ul><ul><ul><li>And its Net Worth (Wealth), the Difference Between Assets and Liabilities </li></ul></ul><ul><li>Is Used to Measure Financial Success Over Time </li></ul>
  4. 4. Nature of the Balance Sheet <ul><li>Balance Sheet Equation </li></ul><ul><li>Assets (A) = Liabilities (L) + Net Worth (NW) </li></ul><ul><li>Example: $10,000 = $6,000 + $4,000 </li></ul><ul><li>Illustrations: </li></ul><ul><li>(1) Family works hard and saves $5,000, which is used to acquire $2,000 more assets while reducing liabilities by $3,000. New balance sheet: $12,000 = $3,000 + $9,000. Note: increase in net worth = savings. </li></ul>
  5. 5. Illustrations, continued <ul><li>Beginning balance sheet: $10,000 = $6,000 + $4,000 </li></ul><ul><li>A = L + NW </li></ul><ul><li>(2) Family consumes all of its income and during the year one of its assets depreciated in value by $3,000. New balance sheet: $7,000 = $6,000 + $1,000. </li></ul><ul><li>Note: Net Worth is What’s Left Over after Liabilities Are Deducted from Assets; that is: NW = A - L </li></ul>
  6. 6. Balance Sheet for the Steele Family: 12/31/01 <ul><li>Assets $325,540 </li></ul><ul><ul><li>Liquid $ 16,240 </li></ul></ul><ul><ul><li>Lifestyle 261,500 </li></ul></ul><ul><ul><li>Investment 47,800 </li></ul></ul><ul><li>Liabilities $168,149 </li></ul><ul><ul><li>Current $ 8,354 </li></ul></ul><ul><ul><li>Noncurrent 159,795 </li></ul></ul><ul><li>Net Worth $157,391 </li></ul>
  7. 7. Steeles’ Liquid Assets <ul><li>Cash $ 240 </li></ul><ul><li>Checking Account 2,400 </li></ul><ul><li>Savings Account 5,600 </li></ul><ul><li>42-Month CD 5,000 </li></ul><ul><li>Series EE Bonds 3,000 </li></ul><ul><li>Total $16,240 </li></ul>
  8. 8. Steeles’ Lifestyle Assets <ul><li>Residence $205,000 </li></ul><ul><li>Household Furnishings 20,000 </li></ul><ul><li>Automobiles and Camper 29,100 </li></ul><ul><li>Jewelry, Clothing, Stamp Coll. 5,800 </li></ul><ul><li>Sporting Equipment 600 </li></ul><ul><li>Riding Mower 1,000 </li></ul><ul><li>Total $261,500 </li></ul>
  9. 9. Steeles’ Investment Assets <ul><li>Common Stocks $ 16,000 </li></ul><ul><li>Mutual Funds 6,800 </li></ul><ul><li>Cash Value: Life Insurance 4,000 </li></ul><ul><li>Cash Value: Retirement Fund 21,000 </li></ul><ul><li>Total $ 47,800 </li></ul>
  10. 10. Steeles’ Current Liabilities <ul><li>Unpaid Bills $ 460 </li></ul><ul><li>Credit Card Balances Due 1,720 </li></ul><ul><li>Estimated Taxes Due 1,750 </li></ul><ul><li>Installment Pmts Due in 1 Year 4,424 </li></ul><ul><li>Total $ 8,354 </li></ul>
  11. 11. Steeles’ Noncurrent Liabilities <ul><li>Mortgage Loan $ 152,829 </li></ul><ul><li>Installment Pmts after 1 Year 4,966 </li></ul><ul><li>Loan on Life Insurance Policy 2,000 </li></ul><ul><li>Total $ 159,795 </li></ul>
  12. 12. Net Worth <ul><li>Is the difference between assets and liabilities </li></ul><ul><li>The most useful concept for measuring wealth </li></ul><ul><li>Can be increased by </li></ul><ul><ul><li>positive contributions to savings </li></ul></ul><ul><ul><li>increases in market values of assets you own </li></ul></ul>
  13. 13. The Income Statement <ul><li>Shows: </li></ul><ul><ul><li>A Family’s Cash Income Over a Given Period of Time, Usually a Year </li></ul></ul><ul><ul><li>Its Cash Expenses for the Same Period </li></ul></ul><ul><ul><li>And its Savings, the Difference Between the Two </li></ul></ul><ul><li>Also Measures Financial Success: A Rising Income Facilitates Goal Achievement </li></ul>
  14. 14. Steeles’ Income Statement: Year Ended 12/31/01 <ul><li>Salaries $75,600 97.4% </li></ul><ul><li>Other Income 2,027 2.6% </li></ul><ul><li>Total Income $ 77,627 100.0% </li></ul><ul><li>Total Expenses 75,033 96.7% </li></ul><ul><li>Savings 2,594 3.3% </li></ul>
  15. 15. Steeles’ Major Expenses % of Total Income <ul><li>Housing 28.0% </li></ul><ul><li>Taxes 23.3 </li></ul><ul><li>Food 10.6 </li></ul><ul><li>Transport. 10.3 </li></ul><ul><li>Others 7.2 </li></ul><ul><li>Leisure 6.5% </li></ul><ul><li>Utilities 4.8 </li></ul><ul><li>Insurance 3.3 </li></ul><ul><li>Clothing 2.7 </li></ul>
  16. 16. Steeles’ Major Expenses Total = $75,033 <ul><li>Housing $21,785 </li></ul><ul><li>Taxes 18,070 </li></ul><ul><li>Food 8,230 </li></ul><ul><li>Transport. 7,998 </li></ul><ul><li>Others 5,550 </li></ul><ul><li>Leisure $ 5,010 </li></ul><ul><li>Utilities 3,750 </li></ul><ul><li>Insurance 2,520 </li></ul><ul><li>Clothing 2,120 </li></ul>
  17. 17. Expenses: Inflexible ($49,133) and Flexible ($25,920) <ul><li>Mortgage $18,285 </li></ul><ul><li>Auto loans 5,668 </li></ul><ul><li>Car Licenses 210 </li></ul><ul><li>Utilities 3,750 </li></ul><ul><li>Taxes 18,070 </li></ul><ul><li>Insurance 2,520 </li></ul><ul><li>Dues 200 </li></ul><ul><li>Tuition, books 390 </li></ul><ul><li>Allowances $ 1,300 </li></ul><ul><li>Leisure 5,010 </li></ul><ul><li>Home furn. 3,500 </li></ul><ul><li>Gas, oil, etc.. 2,100 </li></ul><ul><li>Food, cons. 8,230 </li></ul><ul><li>Clothing 2,120 </li></ul><ul><li>Gifts, contrib.. 2,080 </li></ul><ul><li>Others 1,580 </li></ul>
  18. 18. Evaluating Past Performance <ul><li>Did Your Income Meet or Beat Last Year’s Inflation Rate? </li></ul><ul><li>Did Your Net Worth Increase at the Same Rate as Inflation? </li></ul><ul><li>Are You Maintaining Adequate Liquidity? </li></ul><ul><li>Are You Avoiding Excessive Debt? </li></ul>
  19. 19. Nominal Income versus Real Income <ul><li>Nominal Income is Actual Amount Received </li></ul><ul><li>Real Income Is Nominal Income Adjusted for Inflation </li></ul><ul><li>% Change in Nominal Income Is Calculated </li></ul><ul><li>[this year’s nominal income/last year’s nominal income] - 1 </li></ul><ul><li>Example: [$60,000/$50,000] - 1 = 1.20 - 1 = 0.20 </li></ul><ul><li>Compare Amount to Annual Inflation Rate: 20% versus, say, 3%. Great Performance! </li></ul>
  20. 20. Financial Ratios <ul><li>Measure Financial Strengths and Weaknesses </li></ul><ul><li>Your Ratios Can Be Compared to Those of Other Families </li></ul><ul><li>Care Is Needed in Using Ratios: You Should Look at a Number of Ratios, Rather Than Only One; Also, A Ratio’s Trend Is Important </li></ul>
  21. 21. Steeles’ Financial Ratios Measuring Liquidity <ul><li>Liquid Assets to Take-Home Pay Ratio :* Liquid Assets/ Take-Home Pay = $16,240/$61,030 = 0.266 (Fair) </li></ul><ul><li>Liquidity Ratio : </li></ul><ul><li>Liquid Assets/Current Liabilities = $16,240/$8,354 = 1.94 (Good) </li></ul><ul><ul><ul><li>* Take-Home Pay = Salaries of $75,600 - Payroll Taxes of $14,570 </li></ul></ul></ul>
  22. 22. Steeles’ Financial Ratios Measuring Debt Capacity <ul><li>Debt Ratio : Total Liabilities/Total Assets = </li></ul><ul><li>$168,149/$325,540 = 0.517 (fair) </li></ul><ul><li>Debt Service Coverage Ratio : </li></ul><ul><li>Take-Home Pay/Debt Service Charges = </li></ul><ul><li>$61,030/$24,133 = 2.53 (some weakness) </li></ul>
  23. 23. Simple Rules for Successful Budgeting <ul><li>Set Realistic Budget Goals--a Budget Is not a Straitjacket to Produce Only Savings </li></ul><ul><li>Stick to Simple Procedures </li></ul><ul><li>Use the Budget to Control and Direct Expenses </li></ul>
  24. 24. Preparing an Annual Budget <ul><li>Set Spending/Savings Goals </li></ul><ul><li>Prepare Master Budget Worksheet </li></ul><ul><li>Prepare Monthly Income and Expense Plan </li></ul><ul><li>Evaluate and Control Activities </li></ul><ul><ul><li>Monthly </li></ul></ul><ul><ul><li>At Year End </li></ul></ul>
  25. 25. The Master Budget Worksheet <ul><li>Has the Same Format as the Annual Income Statement </li></ul><ul><li>Allocated Amounts Should Reflect Historical Experience Plus Inflation Adjustment </li></ul><ul><li>Should Focus on Planned Savings </li></ul><ul><li>Should Be Realistic and Achievable </li></ul>
  26. 26. The Monthly Income and Expense Plan <ul><li>Shows Cash Flows by Month </li></ul><ul><li>Indicates Months When Cash Flow May Be Negative </li></ul><ul><li>Negative Cash Flows Require Management </li></ul><ul><ul><li>Will Need Adequate Cash Reserves/ Or </li></ul></ul><ul><ul><li>Will Need to Borrow </li></ul></ul>
  27. 27. Recording Income and Expenses Efficiently <ul><li>Don’t Use Cash--Paying with Checks Provides Written Record </li></ul><ul><li>Create a “Personal Voucher” to Record Any Necessary Cash Outlays </li></ul><ul><li>Code Income and Expense Accounts for Easy Summing </li></ul><ul><li>See if Your Bank Has A Recording System (at reasonable cost to you) </li></ul>
  28. 28. Updating Income and Expense Accounts <ul><li>Each Month Compare Actual Income or Expense with Budgeted Amount </li></ul><ul><li>The Difference is an Account Variance </li></ul><ul><li>Unfavorable Expense Variances Need Attention </li></ul><ul><ul><li>Reduce Spending in Future Periods to Eliminate Variance </li></ul></ul><ul><ul><li>Ideally By Year End, Cumulative Variance = 0 </li></ul></ul>
  29. 29. Controlling Expenses: Meals Eaten Out <ul><li>Monthly Planned </li></ul><ul><li>Expense = $ 80.00 </li></ul><ul><li>Jan. Actual $ 88.00 </li></ul><ul><li>Feb. Actual 102.00 </li></ul><ul><li>Mar. Actual 91.00 </li></ul><ul><li>April Target 39.00 </li></ul><ul><li>Monthly Cumulative </li></ul><ul><li>Variance Variance </li></ul><ul><li>($ 8.00) ($ 8.00) </li></ul><ul><li>( 22.00) ( 30.00) </li></ul><ul><li>( 11.00) ( 41.00) </li></ul><ul><li>41.00 -0- </li></ul>
  30. 30. Next Chapter 4 Taxes

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