Chapter 2: Financial Planning

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Chapter 2 Financial Planning
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Objectives

• Explain the concept of financial planning, its
  components, and its benefits.
• Describe financial statements, particularly the
  balance sheet and the income and expense
  statement.
• Use financial ratios to evaluate your financial
  strength and progress.

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Objectives

• Identify the purposes and methods of financial
  recordkeeping.
• Describe the use of computer software in personal
  financial planning.
• Explain how to choose a professional financial
  planner.

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Financial Planning

• The process of developing and implementing a
  coordinated series of financial plans to achieve
  financial success.

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Common Financial Behaviors
BEWARE!

• No clear goals
• Disorganized records
• Lack of economic understanding
• Flawed decision making

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Components of Successful Financial Planning

• Specified values
• Explicitly stated goals
• Informed economic projections
• Logical and consistent financial strategies

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Financial Statements

• Compilation of financial data
• Communicate information
• Indicate financial condition
• Prepares user to read corporate financial
  statements

FUNCTIONS PERFORMED
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The Balance Sheet
VALUE OF EVERYTHING OWNED MINUS EVERYTHING OWED

• Assets Items owned
• Liabilities- Items owed
• Net worth Difference between what one owns and
  owes.

Assets- Liabilities Net Worth
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Assets

• Monetary or Liquid assets
• Tangible or Household assets
• Investment assets

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Liabilities

• Short-term liabilities anything that will be
  paid off in 12 months or less.
• Long-term liabilitiesanything that will still
  have a balance after 12 months.

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Income - Expense Statement
SUMMARY OF CASH-FLOW TRANSACTIONS OVER TIME

• Income How much you made.
• Expenses How much you spent.
• Net gain or lossHow much you have left.
• Income Expenses Net gain or loss

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Incomes

• Salaries or wages
• Bonuses and commissions
• Child support and alimony
• Public assistance
• Social Security and pensions

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Incomes

• Scholarships and grants
• Interest and dividends
• Income from the sale of assets
• Other income (gifts, tax refunds, rent, royalties)

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Expenses

• Fixed expensesitems that are the same every
  month (you dont have control over these).
• e.g. house payment, car payment, insurance
  premium
• Variable expensesexpense changes based on the
  way you live (you have control over these).
• e.g. meals, utilities, entertainment

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Income Statement
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Balance Sheet
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Financial Ratios

• Basic liquidity ratio
• Debt-to-asset ratio
• Debt-service-to-income ratio
• Investment-assets-to-net-worth ratio

OBJECTIVE ASSESSMENTS OF FINANCIAL STATUS
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Basic Liquidity Ratio
Using the information from the Balance Sheet
earlier in this presentation
Basic Liquidity Ratio
Monetary (Liquid) Assets Monthly Expenses
1,800 1,445 1.25
This ratio shows that this person could pay their
monthly expenses for 1.25 months using monetary
assets.
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Liquidity Ratio
Using the information from the Balance Sheet
earlier in this presentation
Liquidity Ratio
Liquid Assets Current Liabilities
1,800 1,620 1.11
This ratio shows that this person has 1.11
liquid assets for every 1 of current
liabilities.
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Debt-to-Asset Ratio
Debt-to-Asset Ratio
Total Debt Total Assets
3,620 6,200 .58
If your debt is greater than your assets you are
technically insolvent.
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Debt Service-to-Income Ratio
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AnnualDebt Repayment Gross Income
Debt Service-to-Income Ratio
1,800 12,000 .15 or 15
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1. The Annual Debt Payment for this calculation
   includes mortgage
2. Annual debt payment in this example is the car
   loan monthly payment x 12 months (150 x 12
   1,800).

A ratio of 36 or less indicates that gross
income is adequate to make debt repayments.
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Debt Payment-to-Disposable Income Ratio
Debt Payment-to- Disposable Income Ratio
Monthly nonmortgage debt payments Disposable
income
Disposable income is the amount of take-home pay
remaining after all deductions are withheld for
taxes.
A ratio greater than 20 is considered
problematic.
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Investment Assets-to-Net Worth Ratio
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Good Debt vs. Bad Debt

• Debt incurred for consumption is bad debt.

Bad Debt
Debt Danger Ratio
Annual Income
Debt Danger Ratio beyond 25 can spell trouble.
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Assessing Financial Progress

• Balance sheet
• Income - expense statement
• Financial ratios
• Am I spending, saving, and investing money where
  I really want to?

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Financial Recordkeeping

• Where you are
• Where you have been
• Where you are going

DETERMINE
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Recordkeeping Issues

• Original source records
• Safeguarding/storage of records
• Use of computer software

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Professional Financial Planning

• Commission-only
• Fee-only
• Fee-based
• Designations and credentials

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Key Words and Concepts Financial Planning is the
process of developing and implementing a
coordinated series of financial plans to achieve
financial success. Values are fundamental beliefs
about what is important, desirable, and
worthwhile. Financial Goals are the specific
long- and short-term objectives to be attained
through financial planning and management
efforts. Financial Strategies are preestablished
plans of action to be implemented in specific
situations. Financial Statements are compilations
of personal financial data designed to
communicate information on money matters. Balance
Sheet (or net worth statement) describes an
individuals or familys financial condition on a
specified date. Income and Expense (or cash flow)
Statement lists and summarizes income and expense
transactions that have taken place over a
specific period of time. Assets include
everything you own that has monetary
value. Liabilities are your debt. Net Worth is
the dollar amount left when what is owed is
subtracted from the dollar value of what is
owned. Everything should be calculated at fair
market value.
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Key Words and Concepts (Cont.) Fair Market Value
is the amount a buyer would pay a willing
seller. Monetary Assets (or liquid assets)
include cash and near-cash items that can be
readily converted to cash. Tangible (or use)
Assets are physical assets that have fairly long
lifespans and could be sold to raise cash but
whose primary purpose is to provide maintenance
of ones lifestyle. Investment assets (also known
as capital assets) include tangible and
intangible items acquired for the monetary
benefits they provide. Diversification of
investments means the investor puts money in a
variety of investments. Short-term (or current)
Liability is an obligation that will be paid off
within one year. Long-term Liability is an
obligation that will be paid off in more than one
year. Insolvent means net worth is
negative. Fixed Expenses are usually paid in the
same amount during each time period. Variable
Expenses are expenditures over which and
individual has considerable control. Net
Gain/Loss shows the amount of money left after
you subtract expenses from income. Financial
Ratios are objective numerical calculations
designed to simplify making judgmental
assessments of financial strength over time.
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Key Words and Concepts (Concl.) Liquidity is the
speed and ease with which an asset can be
converted into cash. Financial Ratios Basic
Liquidity Ratio monetary (liquid) assets

monetary expenses Reveals the number of
months a family could continue to meets its
expenses from monetary assets after a total loss
of income. Families should have a basic
liquidity ratio of 3. Debt-to-Asset Ratio
total debt
total assets Measures
the solvency and ability to pay debt Debt
Service-to-Income Ratio annual debt repayments

gross income Provides
an incisive view of the total debt burden of an
individual. A ratio of .36 or less indicates that
gross income is adequate to make debt
repayments. Investment Assets-to-Net Worth
Ratio investment assets

net worth Expresses how well an
individual is advancing toward their financial
goals for capital accumulation. Experts
recommend 50 or higher.