PART 1: FINANCIAL PLANNING Chapter 2 Measuring Your Financial Health and Making a Plan

PART 1:FINANCIAL PLANNING

Chapter 2Measuring Your Financial

Health and Making a Plan

© 2007 Prentice Hall Business Publishing Personal Finance: Turning Money Into Wealth Keown

2-2

Measure Your Wealth

The Balance Sheet

Is a statement of your financial position on a given date.

Lists your assets, the liabilities (debts) you’ve incurred, and your net worth.


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Assets: What You Own

All of your possessions are considered assets even if you owe money on them.

Assets are listed using fair market value.


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Different Types of Assets

Monetary assets – are liquid.

Investments.

Retirement plans.

Real estate.

Vehicles.

Personal property.


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Liabilities: What You Owe

Liability is debt that must be repaid in the future.

List only the unpaid balances.


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Different Types of Liabilities

Current liabilities - must be paid off within the next year.

Long-term liabilities – come due beyond a year.

Other liabilities.


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Net Worth: A Measureof Your Wealth

Net worth =

total assets - total debt

Liabilities > assets = negative net worth (insolvency).

Liabilities < assets = positive net worth.

Manage your net worth.


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Trace Your Money

The Income Statement

Tells where your money has come from and where it has gone over a period of time.

Is prepared on a cash basis.Based on actual cash flows.


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Income: Where Your MoneyComes From

Income is amount earned, not amount received.

Sources of income. Automatic investment for retirement plans.

Calculate take-home pay.Subtract taxes.


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Expenditures: Where YourMoney Goes

Fixed expenses.

Variable expenses.

Major expenditures.

Cash transactions may not leave a paper trail.


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Using Ratios: Financial Thermometers

Use financial ratios.

Ratios allow you to analyze data in your balance sheet and income statement and compare the data to targets or to previous performance.


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Financial Ratios Answer These Questions

Do I have enough liquidity to meet emergencies?

Can I meet debt obligations?

Am I saving as much as I think I am?


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Question 1: Do I Have Enough Liquidity to Meet

Emergencies?

Current ratio =

monetary assets

÷

current liabilities

To judge liquidity, compare cash and other liquid assets with debt.

Should be above 2.0; trend is most important.

This ratio does not consider monthly payments towards long-term debt (mortgage, car loans).


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Question 1: Do I Have Enough Liquidity to Meet

Emergencies?

Month’s Living Expenses Covered Ratio =

monetary assets

÷

annual living expenses/12

Tells how many months of living expenses can be covered with present monetary assets.

Liquid assets covering 3-6 months are optimum, less if credit and insurance protection.


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Question 2: Can I MeetMy Debt Obligations?

Debt Ratio =

total debt

÷

total assets

Debt ratio tells you what percentage of your assets has been financed by borrowing.

This ratio should decrease as you age.


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Question 2: Can I MeetMy Debt Obligations?

Long-term Debt Coverage Ratio =

total income available for living expenses

÷

total long-term debt payments

Relates the amount of funds available for debt repayment to the size of the debt payments.

This is the number of times you could make your debt payments with your current income.


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Another Way to Look at Debt Coverage

Total debt payments

÷

Total income available for living expenses

Tells you what % total income available for living expenses goes to cover debt payments.


2-18

Question 3: Am I Saving as Much as I Think I Am?

Savings Ratio =

Income available for savings and investment

÷

Income available for living expenses

It tells you the proportion of your after-tax income that you are saving.


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Record Keeping

Keep and maintain records.

Needed to prepare taxes.

Allows you track expenses and know how much and where you are spending.

Makes it easier for someone to step in during an emergency and understand your financial situation.


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Record Keeping

Involves just 2 steps:Track your financial dealings.File and store your financial records so they are readily accessible.


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Record Keeping

Cash expenditures are more difficult to track.

Record transactions in a ledger.


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Budgeting

A budget is a plan for controlling cash inflows and outflows.

Purpose is to keep income in line with expenditures plus savings.


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Preparing a Cash Budget

Examine last year’s total income and make adjustments for the coming year.

Estimate your taxes and calculate your anticipated after-tax income.

Estimate your living expenses.Identify fixed and variable expenditures.


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Implementing the Cash Budget

At the end of the month, compare your actual income and expenditures with your budgeted amounts.

No budget is set in stone.

Try the envelope system.


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Hiring a Professional

Options:Go it alone; make your own plan and have it checked by a professional.Work with a professional to develop a plan.Leave it all in the hands of a professional.


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Choosing a Professional Planner

Accreditations: Personal financial specialist (PFS) - is a CPA.Certified financial planner (CFP).Chartered financial consultants (ChFh).


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Ascertain the planner’s credentials.

Consider their level of experience.

Ask for referrals.


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Fee-Only Planners - earn income through fees.

Fee and Commission Planners - charge a fee and a commission on products they recommend.


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Fee Offset Planners - charge a fee but reduce it by any commissions earned.

Commission Based Planners - work on a commission basis only.

Make sure your planner has a wide range of choices available.

Documents

PART 1: FINANCIAL PLANNING Chapter 2 Measuring Your Financial Health and Making a Plan