Chapter 2

CHAPTER 2: PERSONAL FINANCIAL STATEMENTS & BUGDETS

Mapping Out Your Financial Future

Financial Plans Financial Tools
Budgets
road maps that show you the way

Financial Statements

let you know where you stand financially detailed short term financial forecast
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* Evaluate and plan major outlays feedback * Reduce taxes * Establish savings and investment programs feedback * Manage credit * Risk management and insurance * Implement retirement program * Facilitate estate distribution

FINANCIAL PLANS

* Monitor and control income, living expenses, purchases, and savings on a monthly basis

BUDGETS

Actual financial results * Balance sheet * Income & expense statement

FINANCIAL STATEMENTS
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Time Value of Money (TVM):

Putting a Dollar Value on Financial Goals

A dollar today is worth more than a dollar received in the future because it can be invested and earn interest.

Single sum
one lump sum investment with no more additions or subtractions.

Annuity
a series of payments made at fixed time intervals for a specified number of periods.

Future Value
The value your invested money will
grow to become earning a specific rate of interest over a given time period. value to a larger future value by applying compound interest is known as compounding.
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The process of growing todays present

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Examples: What will $10,000 grow to if it is invested at 5% for 10 years? What will you have if you invest $10,000 every year for the next 10 years at 5%?
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Present Value
The amount needed today to invest at
a specific rate of interest over a given time period to accumulate the desired future amount. compounding and is the process of working from the future value back to the present value.
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Discounting is the reverse of

Examples:
You wish to accumulate a retirement fund of $1,000,000 at age 62. At 5% p.a. of investment yield, (a) What single lump-sum deposit must you make today? (b) What annual deposits must you make (i) at the beginning of each year; (ii) at the end of each year
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Use Financial Statements to:

Define current financial position. Track changes in financial position over
time.

Monitor progress in achieving goals. Reformulate plans as situations change.

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Balance Sheet
A statement of your financial position at one point in time. A snapshot of your financial position on a particular day

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Balance Sheet Equation:

Liabilities Assets
(what you own)

(what you owe)

+ Net Worth (your worth)

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Balance Sheet
ASSETS (Fair Market Value of Assets)
Liquid assets

LIABILITIES (Outstanding Amount of Loans and Debts)

Current liabilities Long-term liabilities

Investments Real Property Personal Property

NET WORTH (Your Equity Portion)

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The Concept of Solvency:

If your net worth is POSITIVE, you are
SOLVENT and have enough assets to
cover your financial obligations.

If your net worth is (NEGATIVE), you

are INSOLVENT and do not have enough assets to cover your financial obligations technically bankrupt
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Income and Expense Statement

A measure of your financial performance over a given time period, usually one year
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Income and Expense Statement:

Total Income Total Expenses = CASH SURPLUS (DEFICIT)

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Income: Cash IN
Wages and salaries Bonuses and Commissions Interest and dividends Annuity income Rental income Proceeds from sales of assets
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Expenses: Cash OUT

FIXED
Rents mortgage repayments Insurance premiums

VARIABLE
Credit cards payments Recreation Entertainment
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CASH SURPLUS (DEFICIT):

If your income exceeds your
expenses, you have a CASH SURPLUS. your income, you have a CASH DEFICIT.

If your expenses exceed

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How does a Deficit on your Income Statement affect your Net Worth on your Balance Sheet?
Example Assume that all your income for the month has been spent. But you decide you just want to take a holiday trip to Jamaica. The trip costs $3,500.

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Scenario 1: Deplete an Asset Take money from your savings account to pay for the trip.

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Before the purchase:

Assets Liab. Net worth $30,000 $22,000 $ 8,000 Because you took the money from your savings account, your total assets have declined. Your liabilities remain the same, so your Net Worth must decrease.
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After the purchase:

Assets Liab. Net worth $26,500 $22,000 $ 4,500

Scenario 2: Increase a Liability Charge the trip on your charge card.

Before the purchase:

Assets Liab. Net worth $30,000 $22,000 $ 8,000 Because you borrowed money, your total liabilities have increased.

After the purchase:

Assets Liab. Net worth $30,000 $25,500 $ 4,500 Your assets remain the same, so your Net Worth must decrease.
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Deficit spending

DECREASES
your Net Worth!

Tracking Financial Progress Ratio Analysis

Provide warning signals to detect deterioration in financial position, for corrective action(s) to be taken before it is too late A forecast tools to help to assess progress toward financial goals
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Balance Sheet Ratios

To measure Financial Stability

Solvency Ratio =

Total Net Worth Total Assets

How much financial cushion you have

Liquidity Ratio =

Liquid Assets
Total Current Liabilities

Ability to pay off the short term liabilities

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Income & Expense Statement Ratio

Focus on the bottom line of the I/E statement

Saving Ratio =

Cash Surplus Income after Taxes

Proportion of your net income saved in a year

Debt Service Ratio = Total monthly loan payments Monthly gross (before tax) income
A measure of your ability to meet your debt obligations
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Cash Budget
A detailed short-term financial forecast
of income and expenditures

Actual cash inflow and cash outflow To ensure no cash flow problem Help to manage income and
expenditures in the future

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Preparing a Cash Budget:

Estimate income Estimate expenses Determine cash surplus (deficit)

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What should you do if you have monthly deficits?

Shift expenses from months with Use savings, investments, or

borrowing to cover temporary deficits.

deficits to months with surpluses.

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What should you do if you end the year with a deficit?

Liquidate savings/investments. Borrow to cover the deficit. Cut low priority expenses; alter
spending habits.

Increase income.
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Things to remember about a budget:

Compare your budgeted figures

to your actual figures. the actual figures.

Continually update, based upon Always try to keep your budget

balanced or, even better, at a surplus.
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