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© 2008 Thomson South-Western YOUR FINANCIAL STATEMENTS AND PLANS CHAPTER 2

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Chapter 2 of Finance 8, Gitman !0th Edition

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© 2008 Thomson South-Western

YOURFINANCIAL

STATEMENTS AND PLANS

CHAPTER 2

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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

Link future goals and plans with actual results

Provide direction, control and feedback

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The Interlocking Network of Financial Plans & Statements

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Special 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

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Types 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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Time Value of Money

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.

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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 the Future Value of a Single Sum

Example:

What will $5000 grow to become

if invested at 10% for 6 years?

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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

Calculating the Future Value of a Single Sum

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Calculating the Future Value of an Annuity

Example:

What would you accumulate if you could invest $5000 every year for

the next 6 years at 10%?

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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

Calculating the Future Value of an Annuity

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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 the Present 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

Calculating the Present Value of a Single Sum

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Calculating the Present 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 7

I/YR PV $33,872.11

Calculating the Present Value of an Annuity

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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

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

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

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

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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.

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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).

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How We Spend Our Income

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

Current is defined as needing payment within one year.

Liquid assetsTotal current debts

Liquidity Ratios

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

Total monthly loan paymentsMonthly gross income

Debt Service Ratio

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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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Using Budgets

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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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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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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Depletion of an existing asset,

More debt –

Or both DECREASES net worth

Deficit Spending Results In

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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.