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Chapter 2 – Measuring Financial Health

Important parts

• Construct & interpret financial statements

• Budgeting

• Record-keeping

• Financial planners

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Measuring Financial Health

• Balance sheet – as of a particular date– Assets – what you own– Liabilities – what you owe/borrowed– Net Worth – a measure of your wealth

• Assets less liabilities is net worth

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Types of Assets

• Monetary assets – cash• Investments – provide

income• Retirement plans

• Automobiles• Real estate• Personal Property• Other – owed to you

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Liabilities

• Money you owe– Unpaid bills, credit cards, car loans, mortgages

• Only include principal on balance sheet

• Liabilities may be current or long-term

• Net worth equals assets less liabilities

• Insolvent – owe more than assets worth

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Income Statement

• Shows where money comes from and goes– Covers a period of time; uses actual cash flows– Helps you stay solvent

• Variable or discretionary versus fixed or mandatory

• Paper trail is hard to follow

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Ratios – Financial Thermometers

#1. Do I have adequate liquidity to meet

financial emergencies?

– A. Current ratio is liquid assets divided by current liabilities

– B. Months of living expenses covered by liquid assets

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#2 – Ability to Meet Debt

A. Debt ratio asks – What percent of assets financed by

borrowing? – Do I have too much debt?

Debt ratio = Total Debt

Total assets

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Savings

#3 - Am I really saving as much as I think I am?

What percentage of after-tax in come is being saved? Measured by savings ratio

Not saving = living above your means

Pay yourself first!

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Record Keeping

• Organizing and maintaining records is essential for financial planning– For taxes, tracking expenses, preparing family

for an emergency

• Systems – from software to envelope system

• Good checklist on page 46

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What is a Budget?

“A method of going broke methodically”

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Cash Budgets

• Plan for controlling cash inflows and outflows to keep expenditures in line with income

• Done on both monthly and cumulative basis

• Show and explain variances by line item

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The Budget Process

• Purpose: know where money comes from and where it goes.– Take remedial action to control spending– Both forward and backward looking

• Starts with income• Expenses divided into mandatory and

discretionary spending• What’s left should be change in savings

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Budgeting Steps

• Start with latest income statement

• Estimate tax liabilities and other deductions

• Identify fixed (mandatory) expenses

• Identify variable (discretionary) expense– Any way to reduce?

• Calculate amount available for savings.– Is it sufficient to reach goals?

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Financial Planners

Wide range of services:

Help develop plans and budgets; sanity check

Various types – usually registered w/ SEC/state

But often insurance or securities sales people

Understand their compensation arrangements

Do commissions affect recommendations/ judgment?

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