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CHAPTER 2:

YOURFINANCIAL STATEMENTS

AND PLANS

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Mapping Out Your Financial Future

Financial planning facilitates: Greater wealth Financial security Attainment of financial goals

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Financial plans, budgets and statements facilitate financial planning!

Link future goals and plans with actual results

Provide direction, control and feedback

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* evaluate and plan major outlays* reduce taxes* establish savings and investment programs* manage credit* secure adequate insurance* implement retirement program* facilitate estate distribution

FINANCIALPLANS

The Interlocking Network of Financial Plans & Statements

2-5* evaluate and plan major outlays* reduce taxes* establish savings and investment programs* manage credit* secure adequate insurance* implement retirement program* facilitate estate distribution

FINANCIALPLANS

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

BUDGETS

feedback

Actual financial results* balance sheet* income & expenditures statement

FINANCIALSTATE-MENTS

feedback

2-6Special Planning Concerns:

1. Dual income families

2. Employee benefit choices

3. Major life changes, such as:

First job Marriage Children Death of

family member

Divorce Change in

health Loss of job Change in

economy

2-7Types of Financial Planners:

Commissioned salespeople who work for financial institutions.

Fee-only financial planners who work for the individual client.

Planners who charge both fees and commissions, depending on the products and services offered.

Computerized financial plans prepared by financial institutions.

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Financial Planning Designations

Certified Financial Planner (CFP): Requires a comprehensive education in financial planning

Chartered Financial Consultant (ChFC): Financial planning designation for insurance agents

Certified Trust & Financial Advisor (CTFA): Estate planning and trusts expertise, found mostly in the banking industry

Personal Financial Specialist (PFS): Comprehensive planning credential only for CPAs

Chartered Life Underwriter (CLU): Insurance agent designation, often accompanied by the ChFC credential

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Choosing A Financial Planner

Largely unregulated industry (be careful with the self-claimed financial planners)

Tips on choosing a financial planner: – Know what you want– Talk to others (get referrals)– Interview several planners– Check the planner’s background– Get it in writing– Receive regular statements– Reassess the relationship regularly

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Time Value of Money:

Putting a Dollar Valueon Financial Goals

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

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Types of TVM Calculations: Single sum—one lump sum

investment with no more additions or subtractions.

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

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Ways to Calculate TVM:

Formulas

Tables (see Appendices A-D)

Financial calculators

Spreadsheets (ex: Excel)

Internet calculators (search on “calculators”)

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Future Value

The value your invested money will grow to become earning a specific rate of interest over a given time period.

The process of growing today’s present value to a larger future value by applying compound interest is known as “compounding.”

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Calculating theFuture Value of a Single Sum:

Example: What will $5000 grow to become if invested at 10% for 6 years?

Tables

(Find Future Value Factor for 6 years and 10% in Appendix A)

FV = PV x Factor

$5000 x 1.772 =

$8,860

Calculator(Set on 1 P/YR and

END mode.)

5000 +/- PV

6 N

10 I/YR

FV $8,857.81

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Calculating theFuture Value of an Annuity:

Example: What would you accumulate if you could invest $5000 every year for the next 6 years at 10%?

Tables

(Find Future Value Annuity Factor for 6 years and 10% in

Appendix B)

FV = PMT x Factor

$5000 x 7.716 =

$38,580

Calculator

(Set on 1 P/YR and END mode.)

5000 +/- PMT

6 N

10 I/YR

FV $38,578.05

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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.

“Discounting” is the reverse of compounding and is the process of working from the future value back to the present value.

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Calculating thePresent Value of a Single Sum

Example:

You wish to accumulate a retirement fund of $300,000 in 25

years. If you can invest at 7%, what single lump-sum deposit

must you make today in order to achieve your goal?

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Tables(Find Present Value

Factor for 25 years and 7% in Appendix C)

PV = FV x Factor

$300,000 x .184 =

$55,200

Calculator

(Set on 1 P/YR and END mode.)

300000 +/- FV

25 N

7I/YR

PV $55,274.75

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Calculating thePresent Value of an Annuity

Example:

Your rich uncle wishes to give you a sum of money today to use for the next 4 years of college. If you need $10,000

a year and will leave the remainder invested at 7%, how much should you

tell him you need?

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Tables(Find Present Value Annuity Factor for 4

years and 7% in Appendix D.)

PV = PMT x Factor

$10,000 x 3.387 =

$33,870

Calculator

(Set on 1 P/YR and END mode.)

10000 +/- PMT

4 N

7I/YR

PV $33,872.11

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Balance Sheet

A statement of

your financial position

at one point in time.

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Balance Sheet Equation:

LiabilitiesAssets = +

Net Worth

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ASSETS LIABILITIES

(Fair Market Value of Assets)

(Payoff Amount of Loans and Debts)

NET WORTH

(Your Equity Portion)

Balance Sheet

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ASSETS LIABILITIES

What you own:•checking acct.•car•investments•jewelry•furniture

What you owe:•car loan•credit card balances•education loans•unpaid monthly bills

NET WORTH(Subtract total liabilities from total assets todetermine net worth.)

Balance Sheet

2-25The 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.

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The Income and Expense Statement

A measure of your

financial performance

over a given time period.

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Income and Expense Statement:

Total Income – Total Expenses =

CASH SURPLUS OR

(CASH DEFICIT)

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Income: Cash IN

Wages and salaries Bonuses Interest and dividends Child support Tax refunds Gifts

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Expenses: Cash OUT

FIXEDRent or mortgage payment

Cable TV

Insurance

VARIABLEDry cleaning

Recreation

Eating out

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CASH SURPLUS (DEFICIT):

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

If your expenses exceed your income, you have a (CASH DEFICIT).

2-31How We Spend Our Income

Food 13.4%

Housing 32.9%

Transportation 19.3%

Apparel & services 4.4%

Health care 5.5%

Entertainment 4.9%

Personal insurance 1.0%

Pensions/Social Security 8.4%

Other 10.2%

66%

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Using Your Personal Financial Statements

Maintain a good recordkeeping system

Prepare financial statements periodically

Track financial progress

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Ratio Analysis

Financial ratios allow you to:

Track progress toward your financial goals

Evaluate your financial performance over a period of time

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Balance Sheet Ratios

Solvency Ratio

Shows the state of your net worth at a given point in time.

Indicates your potential to withstand financial problems.

Total net worth Total assets

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Example:

$41,420 $147,175 = .28 or 28%

The larger this ratio, the greater the financial cushion to protect against insolvency.

This family could withstand a 28% decline in asset value before they would be insolvent.

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Liquidity Ratio

Measures your ability to pay current debts with existing liquid assets.

Current is defined as needing payment within one year.

Liquid assetsTotal current debts

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Example:

$2,225 $22,589 = .099 or 9.9%

The higher this ratio, the longer the existing liquid assets can cover the yearly living expenses.

This family could last about 1.2 months or 1/10th of a year on their existing liquid assets.

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Savings Ratio

Shows the percentage of after-tax income being saved during a given period.

Income & Expense Statement Ratios

Cash surplusIncome after taxes

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Example:

$11,336 ($73,040 – $15,430) =

0.197 or 19.7%

The higher this ratio, the greater the amount of after-tax income being saved.

This family is doing much better than the national average of 5–8%.

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Debt Service Ratio

Indicates ability to repay loan obligations promptly with before-tax income.

Total monthly loan paymentsMonthly gross income

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Example:

$1,807 $6,807 = .266 or 26.6%

The lower this ratio, the less the difficulty in making monthly loan payments.

This family’s ratio is under 35% and would probably be considered at a manageable level.

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Preparing & Using Budgets

Budget A short-term financial planning

report that helps you achieve your short-term financial goals.

Achieving your short-term goals then helps you achieve your longer-term goals.

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Budgets help you: Monitor and control finances.

Allocate income to reach goals.

Implement system of disciplined spending.

Reduce needless spending.

Achieve long-term financial goals.

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The Budgeting Process

Estimate income

Estimate expenses

Finalize the cash budget

Deal with deficits

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What should you do if you have monthly deficits?

Shift expenses from months with deficits to months with surpluses.

Use savings, investments, or borrowing to cover temporary deficits.

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

Liquidate savings/investments

Borrow to cover the deficit

Cut low priority expenses; alter spending habits

Increase income

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Deficit spending

DECREASES

your Net Worth!

Deficit spending causes you to

Deplete an existing asset,

Incur more debt –

Or both!

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Things to remember about a budget:

Use a Budget Control Schedule to compare your budgeted figures to your actual figures and determine the variances.

Continually update your budget based upon the actual figures.

Always try to keep your budget balanced or, even better, at a surplus.