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Measuring Your Financial Health and Making a Plan

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Learning Objectives
1. Calculate your level of net worth or wealth using a balance sheet. 2. Analyze where your money comes from and where it goes using an income statement. 3. Use ratios to identify your financial strengths and weaknesses.

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Learning Objectives
4. Set up a record-keeping system to track your income and expenditures. 5. Implement a financial plan or budget that will provide for a level of savings needed to achieve your goals. 6. Decide if a professional financial planner will play a role in your financial affairs.

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Introduction
Where does all your money go?

Planning and budgeting requires control


Evaluate your financial health

Develop a plan of action

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Figure 2.1 The Budgeting and Planning Process: Evaluating Your Financial Health and Developing a Plan of Action

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Using a Balance Sheet to Measure Your Wealth


A snapshot of your financial status at a particular time. Assets you own Debt or liabilities youve incurred Your net worth or equity

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Figure 2.2 Personal Balance Sheet

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Assets: What You Own


Assets are your possessions even if you owe money on them. List assets using their fair market value.

All values must be current.

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Assets: What You Own


Monetary assetscash or liquid asset

Investments
Retirement plans

Tangible assetsphysical assets


House, vehicles, furniture, jewelry, collectibles, etc.

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Liabilities: What You Owe


Liability is debt that must be repaid in the future. Current liabilities must be paid off within the next year. Long-term liabilities come due beyond a year.

List only the unpaid balances.

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Liabilities: What You Owe


Current billsutility bills, insurance premiums, credit card balances. Long-term liabilitieshome, car, or student loans. Other loansother installment loans, bank loans, insurance policy loans.

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Net Worth: A Measure of Your Wealth


Net worth = total assets - total debt If liabilities > assets, negative net worth and insolvent.

If liabilities < assets, positive net worth.


Good level of net worth depends on yours goals and your place in the financial life cycle.

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Table 2.1 How Do You Compare?

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Figure 2.3 A Balance Sheet for Louise and Larry Tate, December 31, 2011

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Figure 2.3 A Balance Sheet for Louise and Larry Tate, December 31, 2011 (cont.)

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Using an Income Statement to Trace Your Money


Financial motion picturetells you where your money has come from and where it has gone over some period of time. Income and expenditure, net income statement Cash basisbased on actual cash flows Income expenses (over given time period)

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Figure 2.4 A Simplified Income Statement

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Income: Where Your Money Comes From


Income or cash inflows:
Wages, salary, bonuses, tips, commissions before tax or automatic investments Other sources: family income, government payments (veterans benefits, welfare), investment income

Subtract federal, state, social security taxes from earnings to calculate your take-home pay

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Expenditures: Where Your Money Goes


Cash transactions may not leave a paper trail. Variable or fixed expenditures. Control over expenditures

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Figure 2.5 How Americans Spent Their Money in 2010

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Figure 2.6 Louise and Larry Tates Personal Income Statement

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Figure 2.6 Louise and Larry Tates Personal Income Statement (cont.)

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Using Ratios: Financial Thermometers


Financial ratios allow you analyze raw data in the balance sheet or income statement then compare it to targets. Ratios help you understand how you are managing financial resources.

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Question 1: Do I Have Enough Liquidity to Meet Emergencies?


Current ratio: monetary assets divided by current liabilities
Should be greater than 1.0 Aim for above 2.0

Months Living Expenses Covered Ratio: monetary assets divided by annual living expenditures divided by 12
Should aim for 3 to 6 months of liquid assets Less if enough credit and insurance

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Question 2: Can I Meet My Debt Obligations?


Debt Ratio: total debt or liabilities divided by total assets
Should decrease as you get older.

Long-term Debt Coverage Ratio: total income available for living expenses divided by total long-term debt payments
Less than 2.5 is a red flag

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


Savings Ratio: income available for saving and investments divided by income available for living expenses Effective saving is by paying yourself first

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Record Keeping
Without records difficult to prepare taxes.

You track expenses and know how much and where you are spending.
Easier for someone to step in during an emergency and understand your financial situation.

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Record Keeping Steps


1. Track your financial dealings.
Credit card and check expenditures are easy to track, but cash expenditures must be tracked as they occur. After tracking, record transactions in a ledger.

2. File and store your financial records so they are readily accessible.

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Putting It All Together: Budgeting


Evaluate your financial health by using the balance sheet and income statement:
To set financial goals To achieve financial goals

Develop a plan of action and cash budget using the income statement Monitor your progress using the balance sheet and income statement.

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Developing a Cash Budget


Plan for controlling cash inflows and outflows. Allocate dollar amounts for different spending categories

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Preparing a Cash Budget


Estimate anticipated after-tax income or take home pay from most recent annual personal income statement. Estimate living fixed and variable expenses. Estimate income available for saving and investing: subtract anticipated living expenditures from anticipated take-home pay.
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Implementing the Cash Budget


Put it in place for a month.

Compare actual expenditures in each category with budget amounts at the end of the month.
Evaluate whether you change budget estimates or exert self-control?

Stick your desired budget for a month with an envelope system.


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Figure 2.7 Budget Tracker

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Hiring a Professional
Three options for working with professionals

1.Go it alone and have your plan checked by a professional.


2.Work with a professional to develop a plan. 3.Leave it all in the hands of a pro.

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What Planners Do
More unique financial situations need professional help. They give advice. You still need to know the basics and still bear ultimate responsibility.

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Choosing a Professional Planner Check accreditations:


Personal financial specialist (PFS) Certified financial planner (CFP) Chartered financial consultants (ChFC)

Check experience
Referrals

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Choosing a Professional Planner


Fee-only planners

Fee-and-commission planners
Fee offset planners

Commission based planners

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Summary
Use a balance sheet to determine the level of wealth that you or your family has accumulated on a given date. Use an income statement to understand where your money comes from and goes to be able to save enough to meet goals. Use financial ratios as targets or standards in managing financial resources.

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Summary
A sound record-keeping systems makes tax preparation and tracking of spending easier. Use a budget to plan and evaluate spending and saving.

Professional financial planners can help by validating your plan or developing a plan.

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Figure 2.8 Web-Based Financial Planning with Mint.com

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Figure 2.8 Web-Based Financial Planning with Mint.com (cont.)

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