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th Editio n

12

PERSONAL
FINANCIAL
PLANNING
Lawrence J. Gitman, Ph.D., CFP San Diego State University
Michael D. Joehnk, Ph.D., CFA Arizona State University
Randall S. Billingsley, Ph.D., FRM, CFA Virginia Tech

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

Personal Financial Planning,


Twelfth Edition
Lawrence J. Gitman,
Michael D. Joehnk,
Randall S. Billingsley
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Chapte r

Developing Your Financial


Statements and Plans
L e a r n in g G o a l s
LG1

Understand the interlocking network of financial plans


and statements.

p. 39

LG2

Prepare a personal balance sheet.

p. 41

LG3

Generate a personal income and expense statement.

p. 46

LG4

Develop a good record-keeping system and use ratios


to interpret personal financial statements.

p. 52

LG5

Construct a cash budget and use it to monitor


and control spending.

p. 56

LG6

Describe the use of time value of money concepts


to put a monetary value on financial goals.

p. 63

JOHN-FRANCIS BOURKE/TAXI/GETTY IMAGES

LG1

MAPPING OUT YOUR FINANCIAL FUTURE


On your journey to financial security, you need navigational tools to guide you to your
destination: namely, the fulfillment of your financial goals. Operating without a plan is
like traveling without a road map. Financial plans, financial statements, and budgets
provide direction by helping you work toward specific financial goals. Financial plans
are the road maps that show you the way, whereas personal financial statements let
you know where you stand. Budgets, detailed short-term financial forecasts that compare estimated income with estimated expenses, allow you to monitor and control
expenses and purchases in a manner that is consistent with your financial plans. All
three tools are essential to sound personal financial management and the achievement
of goals. They provide control by bringing the various dimensions of your personal
financial affairs into focus.

personal financial
statements
Balance sheets and
income and expense
statements that serve as
essential planning tools for
developing and monitoring
personal financial plans.

The Role of Financial Statements in Financial Planning


Before you can set realistic goals, develop your financial plans, or effectively manage your money, you must take stock of your current financial situation. Youll also
need tools to monitor your progress. Personal financial statements are planning tools
that provide an up-to-date evaluation of your financial well-being, help you identify
potential financial problems, and help you make better-informed financial decisions.

Chapter 2 | Developing Your Financial Statements and Plans

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39

They measure your financial condition so you can establish realistic financial goals
and evaluate your progress toward those goals. Knowing how to prepare and interpret personal financial statements is a cornerstone of personal financial planning.
Two types of personal financial statementsthe balance sheet and income and
expense statementare essential to developing and monitoring personal financial
plans. They show your financial position as it actually exists and report on financial
transactions that have really occurred.
The balance sheet describes your financial positionthe assets you hold, less the
debts you owe, equal your net worth (general level of wealth)at a given point in
time. This planning tool helps you track the progress youre making in building up
your assets and reducing your debt.
In contrast, the income and expense statement measures financial performance
over time. It tracks income earned, as well as expenses made, during a given period
(usually a month or a year). You use this tool to compare your actual expenses and
purchases with the amounts budgeted and then make the necessary changes to correct
discrepancies between the actual and budgeted amounts. This information helps you
control your future expenses and purchases so youll have the funds needed to carry
out your financial plans.
Budgets, another type of financial report, are forward looking. Budgets allow you to
monitor and control spending because they are based on expected income and expenses.
Exhibit 2.1 summarizes the various financial statements and reports and their relationship to each other in the personal financial planning process. Note that financial plans
provide direction to annual budgets, whereas budgets directly affect both your balance
sheet and your income and expense statement. As you move from plans to budgets to
actual statements, you can compare your actual results with your plans. This will show
you how well you are meeting your financial goals and staying within your budget.

balance sheet
A financial statement
that describes a persons
financial position at a
given point in time.

income and expense


statement
A financial statement
that measures financial
performance over time.

budget
A detailed financial report
that looks forward, based
on expected income and
expenses.

Exhibit 2.1

The Interlocking Network of Financial Plans and Statements

Evaluate and plan major outlays


Manage credit
Secure adequate insurance coverage
Establish savings/investment programs
Manage employee benefits
Reduce taxes
Implement retirement program
Minimize estate taxes

Financial
plans

Monitor and control income,


living expenses, purchases,
and savings on a monthly basis

Budgets

Actual financial results:


Balance sheet
Income and expense statement

Financial
statements

Feedback

Feedback

Personal financial planning involves a network of financial reports that link future goals and plans with actual results.
Such a network provides direction, control, and feedback.

40

Part 1 | Foundations of Financial Planning

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

Assessing Your Financial Situation, Plans, and Goals


As you learned in Chapter 1, the financial planning process includes six steps that
translate personal financial goals into specific financial plans and the strategies to
achieve these goals. In addition to clearly defining your financial goals in measurable
terms, you need to put target dates and a monetary value on your short-term, intermediate, and long-term goals. Well discuss the various types of financial statements
and plans in this chapter. Then well look at how to use time value of money concepts to calculate the value of a financial goal that occurs years into the future.

Concept Check
2-1

LG2

What are the two types of personal financial statements? What is a budget, and
how does it differ from personal financial statements? What role do these reports
play in a financial plan?

THE BALANCE SHEET: HOW MUCH ARE YOU


WORTH TODAY?
Because you should track your progress toward your financial goals, you need a starting point that shows how much youre worth today. Preparing a personal balance
sheet, or statement of financial position, will give you this important information.
This financial statement represents a persons (or familys) financial condition at a
certain point in time. Think of a balance sheet as a snapshot taken of your financial
position on one day out of the year.
A balance sheet has three parts that, taken together, summarize your financial
picture:

Assets: What you own


Liabilities, or debts: What you owe
Net worth: The difference between your assets and liabilities

The accounting relationship among these three categories is called the balance
sheet equation and is expressed as follows:
Total assets  Total liabilities  Net worth
or
Net worth  Total assets  Total liabilities
Lets now look at the components of each section of the balance sheet.

Assets: The Things You Own


assets
Items that one owns.

liquid assets
Assets that are held in the
form of cash or that can
readily be converted to
cash with little or no loss
in value.

Assets are the items you own. An item is classified as an asset no matter if it was
purchased for cash or financed with debt. In other words, even if you havent fully
paid for an asset, you should list it on the balance sheet. In contrast, an item thats
leased is not shown as an asset because someone else actually owns it.
A useful way to group assets is on the basis of their underlying characteristics and
uses. This results in four broad categories: liquid assets, investments, real property,
and personal property.

Liquid assets: Low-risk financial assets held in the form of cash or instruments
that can readily be converted to cash with little or no loss in value. They help
us meet the everyday needs of life and provide for emergencies and unexpected

Chapter 2 | Developing Your Financial Statements and Plans

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41

investments

opportunities. Cash on hand or in a checking or savings account, money market


deposit accounts, money market mutual funds, or certificates of deposit that
mature within 1 year are all examples of liquid assets.
Investments: Assets acquired to earn a return rather than provide a service. These
assets are mostly intangible financial assets (stocks, bonds, mutual funds, and
other types of securities), typically acquired to achieve long-term personal financial goals. Business ownership, the cash value of life insurance
and pensions, retirement funds such as IRAs and 401(k) plans,
and other investment vehicles such as commodities, financial
futures, and options represent still other forms of investment
assets. (For retirement fund accounts, only those balances that
are eligible to be withdrawn should be shown as an asset on
the balance sheet.) They vary in marketability (the ability to sell
quickly) from high (stocks and bonds) to low (real estate and
business ownership investments).
Real and personal property: Tangible assets that we use in our
everyday lives. Real property refers to immovable property:
land and anything fixed to it, such as a house. Real property
generally has a relatively long life and high cost, and it may
appreciate, or increase in value. Personal property is movable property, such as automobiles, recreational equipment,
household furnishings and appliances, clothing, jewelry,
home electronics, and similar items. Most types of personal
property depreciate, or decline in value, shortly after being
put into use.
GRAHAM S. KLOTZ, 2009/USED UNDER LICENSE FROM SHUTTERSTOCK.COM

Assets such as stocks,


bonds, mutual funds,
and real estate that are
acquired in order to
earn a return rather than
provide a service.

real property
Tangible assets that are
immovable: land and
anything fixed to it, such
as a house.

personal property
Tangible assets that are
movable and used in
everyday life.

fair market value


The actual value of an
asset, or the price for
which it can reasonably be
expected to sell in the open
market.

liabilities
Debts, such as credit
card charges, loans, and
mortgages.

current (short-term)
liability
Any debt due within 1 year
of the date of the balance
sheet.

42

About 40% of the average households assets consists of


financial assets (liquid assets and investments); nearly half is real
property (including housing); and the rest is other nonfinancial
assets. The first section of Worksheet 2.1 lists some of the typical
assets youd find on a personal balance sheet.
All assets, regardless of category, are recorded on the balance sheet at their current fair market value, which may differ considerably from their original purchase
price. Fair market value is either the actual value of the asset (such as money in a
checking account) or the price for which the asset can reasonably be expected to sell
in the open market (as with a used car or a home).
If youve taken an accounting course, you will notice a difference between the
way assets are recorded on a personal balance sheet and a business balance sheet.
Under generally accepted accounting principles (GAAP), the accounting professions guiding rules, assets appear on a companys balance sheet at cost, not at fair
market value. One reason for the disparity is that in business, an assets value is
often subject to debate and uncertainty. The user of the statements may be an investor, and accountants like to be conservative in their measurement. For purposes
of personal financial planning, the user and the preparer of the statement are one
and the same. Besides, most personal assets have market values that can be easily
estimated.

Liabilities: The Money You Owe


Liabilities represent an individuals or familys debts. They could result from department store charges, bank credit card charges, installment loans, or mortgages on
housing and other real estate. A liability, regardless of its source, is something that
you owe and must repay in the future.
Liabilities are generally classified according to maturity.

Current, or short-term, liability: Any debt currently owed and due within 1 year
of the date of the balance sheet. Examples include charges for consumable goods,

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Worksheet 2.1

Balance Sheet for Bob and Cathy Case

A balance sheet is set up to show what you own on one side (your assets) and how you pay for them on the other
(debt or net worth). As you can see, the Cases have more assets than liabilities.

BALANCE SHEET

Name(s)

Bob and Cathy case


ASSETS

Liquid Assets
Cash on hand
In checking
Savings accounts
Money market
funds and deposits

LIABILITIES

90
575
760
800

Certificates of deposit
Total Liquid Assets

Investments
Stocks
Bonds
Corp.
Certificates of deposit
Mutual funds
Real estate
Retirement funds, IRA
Other
Total Investments
Real Property
Primary residence
Second home
Other
Total Real Property

December 31, 2010

Date

2,225

1,250
1,000
1,500
2,000
$

5,750

$ 185,000

$ 185,000

Personal Property
Auto(s): 07 Toyata Corolla $ 12,000
Auto(s): 05 Ford Focus
8,300
Recreational vehicles
Household furnishings
3,700
Jewelry and artwork
1,500
Other
Other
Total Personal Property
$

Current Liabilities
Utilities
Rent
Insurance premiums
Taxes
Medical/dental bills
Repair bills
Bank credit card balances
Dept. store credit card
balances
Travel and entertainment
card balances
Gas and other credit card
balances
Bank line of credit
balances
Other current liabilities
Total Current Liabilities

(from parents)

(I)Total Assets $ 218,475

120

75
395
145
125

45
$

905

Long-Term Liabilities
Primary residence mortgage $160,000
Second home mortgage
Real estate investment
mortgage
Auto loans
4,250
Appliance/furniture loans
800
Home improvement loans
Single-payment loans
3,800
Education loans
Margin loans
Other long-term loans

4,000

Total Long-Term Liabilities

25,500

$ 172,850

(II) Total Liabilities $ 172,850


Net Worth [(I) (II)] $ 45,625
Total Liabilities and Net Worth $ 218,475

open account credit


obligations
Current liabilities that
represent the balances
outstanding against
established credit lines.

long-term liability
Any debt due 1 year or
more from the date of the
balance sheet.

utility bills, rent, insurance premiums, taxes, medical bills, repair bills, and total
open account credit obligationsthe outstanding balances against established
credit lines (usually through credit card purchases).
Long-term liability: Debt due 1 year or more from the date of the balance sheet.
These liabilities typically include real estate mortgages, most consumer installment loans, education loans, and margin loans used to purchase securities.

You must show all types of loans on your balance sheet. Although most loans will fall
into the category of long-term liabilities, any loans that come due within a year should

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43

be shown as current liabilities. Examples of short-term loans include a 6-month, singlepayment bank loan, and a 9-month consumer installment loan for a refrigerator.
Regardless of the type of loan, only the latest outstanding loan balance should be
shown as a liability on the balance sheet, because at any given time it is the balance still
duenot the initial loan balancethat matters. Another important and closely related
point is that only the principal portion of a loan or mortgage should be listed as a liability on the balance sheet. In other words, you should not include the interest portion of
your payments as part of your balance sheet debt. The principal defines the amount of
debt you owe at a given time and does not include any future interest payments.
Lenders evaluate a prospective borrowers liabilities carefully. High levels of debt
and overdue debts are both viewed with disfavor. Youll find the most common categories of liabilities on Worksheet 2.1.

Net Worth: A Measure of Your Financial Worth


net worth
An individuals or familys
actual wealth; determined
by subtracting total
liabilities from total assets.

equity
The actual ownership
interest in a specific asset
or group of assets.

insolvency
The financial state in
which net worth is less
than zero.

Go to Smart Sites
Whats the fair market
value of your car? The
personal watercraft your
uncle gave you? Whenever
you see Go to Smart
Sites in this chapter, visit
www.cengage.com/
finance/gitman for online
resources.

Now that youve listed what you own and what you owe, you can calculate your
net worth, the amount of actual wealth or equity that an individual or family has in
owned assets. It represents the amount of money youd have left after selling all your
owned assets at their estimated fair market values and paying off all your liabilities
(assuming there are no transaction costs). As noted earlier, every balance sheet must
balance so that total assets equal total liabilities plus net worth. Rearranging this equation, we see that net worth equals total assets minus total liabilities. Once you establish
the fair market value of assets and the level of liabilities, you can easily calculate net worth
by subtracting total liabilities from total assets. If net worth is less than zero, the family is
technically insolvent. Although this form of insolvency doesnt mean that the family will
end up in bankruptcy proceedings, it likely shows insufficient financial planning.
Net worth typically increases over the life cycle of an individual or family, as
Exhibit 2.2 illustrates. For example, the balance sheet of a college student will probably
be fairly simple. Assets would include modest liquid assets (cash, checking, and savings
accounts) and personal property, which may include a car. Liabilities might include utility bills, perhaps some open account credit obligations, and automobile and education
loans. At this point in life, net worth would typically be low, because assets are small in
comparison with liabilities. A 29-year-old single schoolteacher would have more liquid
assets and personal property, may have started an investment program, and may have
purchased a condominium. Net worth would be rising but may still be low owing to the
increased liabilities associated with real and personal property purchases. The higher net
worth of a two-career couple in their late 30s with children would reflect a greater proportion of assets relative to liabilities as they save for college expenses and retirement.
The level of net worth is important in the long-term financial planning process.
Once you have established a goal of accumulating a certain level or type of wealth,
you can track progress toward that goal by monitoring net worth.

Balance Sheet Format and Preparation


You should prepare your personal balance sheet at least once a year, preferably every 3
to 6 months. Heres how to do it, using the categories in Worksheet 2.1 as a guide.
1. List your assets at their fair market value as of the date you are preparing the
balance sheet. Youll find the fair market value of liquid and investment assets
on checking and savings account records and investment account statements.
Estimate the values of homes and cars using published sources of information,
such as advertisements for comparable homes and the Kelley Blue Book for
used car values. Certain itemsfor example, homes, jewelry, and artworkmay
appreciate, or increase in value, over time. The values of assets like cars and most
other types of personal property will depreciate, or decrease in value, over time.
2. List all current and long-term liabilities. Show all outstanding charges, even if you
havent received the bill, as current liabilities on the balance sheet. For example,

44

Part 1 | Foundations of Financial Planning

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Exhibit 2.2

Median Net Worth by Age

Net worth starts to build in the less-than-35 age bracket and continues to climb, peaking around the 5564 age
bracket. It starts to decline once a person retires and begins to use assets to meet living expenses, usually around
the age of 65.
$253,700

$260,000

$239,400
$240,000
$220,000

$213,500

$200,000
$182,500
$180,000

Median Net Worth

$160,000
$140,000
$120,000
$100,000

$86,600

$80,000
$60,000
$40,000
$20,000
$11,800
$10,000
$0
Less than 35 3544

4554

5564

6574

75 or more

Age
Source: Adapted from Brian K. Bucks, Arthur B. Kennickell, Traci L. Mach, and Kevin B. Moore, Changes in U.S. Family Finances from 2004 to 2007:
Evidence from the Survey of Consumer Finances, Federal Reserve Bulletin, Board of Governors of the Federal Reserve System, Washington, DC, vol. 95
(February 2009), pp. A1A55, http://www.federalreserve.gov/pubs/oss/oss2/2007/scf2007home.html, accessed April 2009.

assume that on June 23 you used your Visa card to charge $500 for a set of tires.
You typically receive your Visa bill around the 10th of the following month. If
you were preparing a balance sheet dated June 30, you should include the $500
as a current liability even though the bill wont arrive until July 10. Remember to
list only the principal balance of any loan obligation.
3. Calculate net worth. Subtract your total liabilities from your total assets. This is
your net worth, which reflects the equity you have in your total assets.

A Balance Sheet for Bob and Cathy Case


What can you learn from a balance sheet? Lets examine a hypothetical balance sheet
as of December 31, 2010, prepared for Bob and Cathy Case, the young couple (ages
28 and 26) we met in Chapter 1 (see Worksheet 2.1). Assets are listed on the left side,
with the most liquid first; liabilities are on the right, starting with the most recent.
The net worth entry is at the bottom right of the statement, just below the liabilities.
The statement should balance: total assets equal the sum of total liabilities and net
worth, as in the balance sheet equation on page 41. Heres what this financial statement tells us about the Cases financial condition.

Chapter 2 | Developing Your Financial Statements and Plans

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45

Assets: Given their ages, the Cases asset position looks quite good. Their
dominant asset is their townhouse. They also have $5,750 in investments, which
include retirement funds, and appear to have adequate liquid assets to meet their
bill payments and cover small, unexpected expenses.
Liabilities: The Cases primary liability is the $160,000 mortgage on their
townhouse. Their equity, or actual ownership interest, in the townhouse is
approximately $25,000 ($185,000 market value minus $160,000 outstanding
mortgage loan). Their current liabilities are $905, with other debts of $12,850
representing auto, furniture, and education loans as well as a loan from their
parents to help with the down payment on their home.
Net worth: The Cases net worth ($218,475 in total assets minus total liabilities of
$172,850) is $45,625considering their ages, a respectable amount that is well
above the median shown in Exhibit 2.2.

Comparing the Cases total liabilities to their total assets gives a more realistic
view of their current wealth position than merely looking at assets or liabilities alone.
By calculating their net worth periodically, the Cases can measure their progress
toward achieving their financial goals.

Concept Check

LG3

2-2

Describe the balance sheet, its components, and how you would use it in personal financial planning. Differentiate between investments and real and personal
property.

2-3

What is the balance sheet equation? Explain when a family may be viewed as
technically insolvent.

2-4

Explain two ways in which net worth could increase (or decrease) from one
period to the next.

THE INCOME AND EXPENSE STATEMENT:


WHAT WE EARN AND WHERE IT GOES

cash basis
A method of preparing
financial statements in
which only transactions
involving actual cash
receipts or actual cash
outlays are recorded.

46

When confronted with a lack of funds, the first question people ask themselves is,
Where does all the money go? Preparing an income and expense statement would
answer this question. Whereas the balance sheet describes a persons or familys
financial position at a given time, the income and expense statement captures the various financial transactions that have occurred over timenormally over the course
of a year, although it technically can cover any time period (month, quarter, and so
on). Think of this statement as a motion picture that not only shows actual results
over time but also lets you compare them with budgeted financial goals. Equally
important, the statement allows you to evaluate the amount of saving and investing
during the period it covers.
Like the balance sheet, the income and expense statement has three major
parts: income, expenses, and cash surplus (or deficit). A cash surplus (or deficit) is
merely the difference between income and expenses. The statement is prepared on
a cash basis, which means that only transactions involving actual cash receipts or
actual cash outlays are recorded. The term cash is used in this case to include not only
coin and currency but also checks and debit card transactions drawn against checking
and certain types of savings accounts.

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Income and expense patterns change over the individuals or familys life cycle.
Income and spending levels typically rise steadily to a peak in the 4554 age bracket.
On average, people in this age group, whose children are typically in college or no
longer at home, have the highest level of income. They also spend more than other
age groups on entertainment, dining out, transportation, education, insurance, and
charitable contributions. Families in the 3544 age bracket have slightly lower average levels of income and expenses but very different spending patterns. Because they
tend to have school-age children, they spend more on groceries, housing, clothing,
and other personal needs. Yet the average percentage of pre-tax income spent is about
the sameat around 75% to 80%for all age brackets through age 64. It rises
sharply to about 97%, however, for persons age 65 and over.

Income: Cash In
income
Earnings received as
wages, salaries, bonuses,
commissions, interest and
dividends, or proceeds
from the sale of assets.

Go to Smart Sites
For current surveys and
trends on consumer
spending, check out the
Consumer Expenditure
Survey at the Department
of Labors Bureau of Labor
Statistics.

Common sources of income include earnings received as wages, salaries, selfemployment income, bonuses, and commissions; interest and dividends received
from savings and investments; and proceeds from the sale of assets such as stocks
and bonds or an auto. Other income items include pension, annuity, and Social
Security income; rent received from leased assets; alimony and child support; scholarships or grants; tax refunds; and miscellaneous types of income. Worksheet 2.2,
Bob and Cathy Cases Income and Expense Statement, has general categories for
recording income.
Note also that the proper figure to use is gross wages, salaries, and commissions,
which constitute the amount of income you receive from your employer before taxes
and other payroll deductions. The gross value is used because the taxes and payroll
deductions will be itemized and deducted as expenses later in the income and expense
statement. Therefore, you should not use take-home pay, because it understates your
income by the amount of these deductions.

Expenses: Cash Out


expenses
Money spent on living
expenses and to pay taxes,
purchase assets, or repay
debt.

fixed expenses
Contractual, predetermined
expenses involving equal
payments each period.

variable expenses
Expenses involving
payment amounts that
change from one time
period to the next.

Expenses represent money used for outlays. Worksheet 2.2, Bob and Cathy Cases
Income and Expense Statement, categorizes them by the types of benefits they
provide: (1) living expenses (such as housing, utilities, food, transportation, medical, clothing, and insurance), (2) tax payments, (3) asset purchases (such as autos,
stereos, furniture, appliances, and loan payments on them), and (4) other payments
for personal care, recreation and entertainment, and other expenses. Some are
fixed expensesusually contractual, predetermined, and involving equal payments
each period (typically each month). Examples include mortgage and installment
loan payments, insurance premiums, professional or union dues, club dues, monthly
savings or investment programs, and cable TV fees. Others (such as food, clothing,
utilities, entertainment, and medical expenses) are variable expenses, because their
amounts change from one time period to the next.
Exhibit 2.3 shows the average annual expenses by major category as a percentage
of after-tax income. Its a useful benchmark to see how you compare with national
averages. However, your own expenses will vary according to your age, lifestyle,
and where you live. For example, it costs considerably more to buy a home in San
Francisco than in Indianapolis. Similarly, if you live in the suburbs, your commuting
expenses will be higher than those of city dwellers.

Cash Surplus (or Deficit)


The third component of the income and expense statement shows the net result of
the periods financial activities. Subtracting total expenses from total income gives
you the cash surplus (or deficit) for the period. At a glance, you can see how you
did financially over the period. A positive figure indicates that expenses were less

Chapter 2 | Developing Your Financial Statements and Plans

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

47

Worksheet 2.2

Income and Expense Statement for Bob and Cathy Case

The income and expense statement essentially shows what you earned, how you spent your money, and how much
you were left with (or, if you spent more than you took in, how much you went in the hole).

INCOME AND EXPENSE STATEMENT

Bob and Cathy case


Name(s)
Year
For the

Ended December 31, 2010

INCOME

Wages and salaries

Self-employment income
Bonuses and commissions
Investment income

Name: Bob Case


Name: Cathy Case
Name:

55,000
15,450

2,495
55
40

Bob-sales commissions
Interest received
Dividends received
Rents received
Sale of securities
Other

Pensions and annuities


Other income
(I) Total Income $

73,040

EXPENSES

Housing

Utilities

Food
Transportation

Medical

Clothing
Insurance

Taxes
Appliances, furniture, and
other major purchases
Personal care
Recreation and
entertainment
Other items

Rent/mortgage payment
(include insurance and taxes, if applicable)
Repairs, maintenance, improvements
Gas, electric, water
Phone
Cable TV and other
Groceries
Dining out
Auto loan payments
License plates, fees, etc.
Gas, oil, repairs, tires, maintenance
Health, major medical, disability insurance
(payroll deductions or not provided by employer)
Doctor, dentist, hospital, medicines
Clothes, shoes, and accessories
Homeowners (if not covered by mortgage payment)
Life (not provided by employer)
Auto
Income and social security
Property (if not included in mortgage)
Loan payments
Purchases and repairs
Laundry, cosmetics, hair care
Vacations
Other recreation and entertainment

Tuition and books: Cathy


Gifts
Loan payments: Education loans
Loan payments: Parents
(II) Total Expenses $
CASH SURPLUS (OR DEFICIT) [(I)  (II)]

48

11,820
1,050
1,750
480
240
2,425
3,400
2,520
250
2,015
2,069
305
1,700
1,320
1,260
1,935
15,430
2,040
800
450
700
2,000
2,630
1,400
215
900
600
61,704
11,336

Part 1 | Foundations of Financial Planning

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

Exhibit 2.3

How We Spend Our Income

Just three categories account for almost two-thirds of spent after-tax income: food, housing, and transportation.

Food12.6%
Housing33.8%
Apparel and services3.9%
Transportation17.6%
Entertainment4.9%
Health care5.7%
Pensions/Social Security10.2%
Life and personal insurance0.7%
Other10.6%

Source: Consumer Expenditures in 2006, Washington, DC: U.S. Department of Labor, Bureau of Labor Statistics, Report 1010, October 2008, p. 4.

cash surplus
An excess amount of
income over expenses that
results in increased net
worth.

cash deficit
An excess amount of
expenses over income,
resulting in insufficient
funds as well as in
decreased net worth.

than income, resulting in a cash surplus. A value of zero indicates that expenses
were exactly equal to income for the period, while a negative value means that your
expenses exceeded income and you have a cash deficit.
You can use a cash surplus for savings or investment purposes, to acquire
assets, or to reduce debt. Adding to savings or investments should increase your
future income and net worth, and making payments on debt affects cash flow
favorably by reducing future expenses. In contrast, when a cash deficit occurs,
you must cover the shortfall from your savings or investments, reduce assets, or
borrow. All of these strategies will reduce net worth and negatively affect your
financial future.
It is important to keep in mind that a cash surplus does not necessarily mean
that funds are simply lying around waiting to be used. Because the income and
expense statement reflects what has actually occurred, the actual disposition of
the surplus (or deficit) is shown in the asset, liability, and net worth accounts on
the balance sheet. For example, if you used the surplus to make investments, this
would increase the appropriate asset account. If you used the surplus to pay off a
loan, the payment would reduce that liability account. Of course, if you used the
surplus to increase cash balances, youd have the funds to use. In each case, your
net worth increases. Surpluses increase net worth; deficits decrease it, whether the
shortfall is financed by reducing an asset (for example, drawing down a savings
account) or by borrowing.

Preparing the Income and Expense Statement


As shown in Worksheet 2.2, the income and expense statement is dated to define the
period covered. To prepare the statement, follow these steps.
1. Record your income from all sources for the chosen period. Use your paycheck
stubs to verify your gross pay for the period, and be sure to include bonuses,

Chapter 2 | Developing Your Financial Statements and Plans

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

49

commission checks, and overtime pay. Youll find interest earned, securities
bought and sold, interest and dividends received, and other investment matters
on your bank and investment account statements. Keep a running list of other
income sources, such as rents, tax refunds, and asset sales.
2. Establish meaningful expense categories. Those shown on Worksheet 2.2 are a
good starting point. Information on monthly house (or rent) payments, loan payments, and other fixed payments (such as insurance premiums and cable TV) is
readily available from either the payment book or your checkbook (or, in the case
of payroll deductions, your check stubs). (Note: Be careful with adjustable-rate
loans, because the amount of monthly loan payments will eventually change when
the interest rate changes.)
3. Subtract total expenses from total income to get the cash surplus (a positive number) or deficit (a negative number). This bottom line summarizes the net cash
flow resulting from your financial activities during the period.
Youll probably pay for most major variable expenses by check, debit card, or
credit card, so its easy to keep track of them. Its harder to keep tabs on all the
items in a month that you pay for with cash, such as parking, lunches, movies, and
incidentals. Most of us dont care to write down every little expense to the penny.
You might try counting the cash in your wallet at the beginning of the month, then
count again after a week goes by to see how much money has been spent. Try to
remember what you spent during the week, and write it down on your calendar to
the nearest $5. If you cant remember, then try the exercise over shorter and shorter
periods until you can.
Just as you show only the amounts of cash actually received as income, record
only the amounts of money you actually pay out in cash as expenses. If you borrow
to acquire an item, particularly an asset, include only the actual cash payment
purchase price minus amount borrowedas an expense, as well as payments on the
loan in the period you actually make them. You show credit purchases of this type
as an asset and corresponding liability on the balance sheet. Record only the cash
payments on loans, not the actual amounts of the loans themselves, on the income
and expense statement.
For example, assume that you purchase a new car for $20,000 in September. You
make a down payment of $3,000 and finance the remaining $17,000 with a 4-year,
5.5% installment loan payable monthly. Your September 30 income statement would
show a cash expenditure of $3,000, and each subsequent monthly income statement
would include your monthly loan payment of $395. Your September 30 balance
sheet would show the car as an asset valued at $20,000 and the loan balance as a
$17,000 long-term liability. The market value of the car and the loan balance would
be adjusted on future balance sheets.
Finally, when making your list of expenses for the year, remember to include the
amount of income tax and Social Security taxes withheld from your paycheck as
well as any other payroll deductions (health insurance, savings plans, retirement and
pension contributions, and professional/union dues). These deductions (from gross
wages, salaries, bonuses, and commissions) represent personal expenses, even if they
dont involve a direct cash payment.
You might be shocked when listing whats taken out of your paycheck. Even
if youre in a fairly low federal income tax bracket, your paycheck could easily be
reduced by more than 25% for taxes alone. Your federal tax could be withheld at
15%, your state income tax could be withheld at 5%, and your Social Security and
Medicare tax could be withheld at 7.65%. That doesnt even count health and disability income insurance.
Preparing income and expense statements can involve a lot of number crunching.
Fortunately, some good computer software packages, such as Quicken and Microsoft
Money, can simplify the job of preparing personal financial statements and doing
other personal financial planning tasks. Exhibit 2.4 describes some currently free
Web sites that are useful for tracking your money online.

50

Part 1 | Foundations of Financial Planning

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

Exhibit 2.4

Tracking Your Money Onlineand for Free!

Theres plenty of software to help you track your spending, income, and investments. While much of it is reasonably
priced, its hard to beat some outstanding free online money tracking programs. Their cost is currently limited to the
time spent setting them up, which can take up to several hours. Here is a sample of programs that provide the details
of your finances with the convenience of Web access.
Moneycenter
.yodlee.com

Mint.com

QuickenOnline.com

Wesabe.com

Coverage

Bank accounts,
loans, credit
cards, and
investments

Bank accounts, loans,


credit cards, and
investments

Bank accounts,
loans, credit
cards, frequent
flyer miles, real
estate, and
investments

Bank accounts and


credit cards

Strengths

Shows allocation
and rates of
return; graphical
displays helpful

Influence of welldeveloped Quicken


software evident
deep customer
support; Money
magazines pick
of the group

Captures many
account types

Stores user names


and passwords
on personal
computer, not on
the sites server

Limitations

Advertising
integrated with
the information
you get

Cant synchronize the


online program
with Quicken
software, on
which detailed
investment
analysis relies.

Needed information
is harder to find

Cant currently track


investments;
emphasis on
exchange of
member ideas
may not appeal
to all users

Source: Adapted from Joe Light, See All Your Money at a Single Glance, Money, December 2008, p. 36. 2008 Time, Inc. All rights reserved.

An Income and Expense Statement


for Bob and Cathy Case
Bob and Cathy Cases balance sheet in Worksheet 2.1 shows us their financial condition as of December 31, 2010. Worksheet 2.2, their income and expense statement
for the year ended December 31, 2010, was prepared using the background material
presented earlier, along with the Cases balance sheet. This statement shows how cash
flowed into and out of their pockets.

Income: Total income for the year ended December 31, 2010, is $73,040. Bobs
wages clearly represent the familys chief source of income, although Cathy has
finished her MBA and will now be making a major contribution. Other sources
of income include $55 in interest on their savings accounts and bond investments
and $40 in dividends from their common stock holdings.
Expenses: Total expenses for the year of $61,704 include their home mortgage,
food, auto loan, clothing, and income and Social Security taxes. Other sizable
expenses during the year include home repairs and improvements, gas and electricity, auto license and operating expenses, insurance, tuition, and education loan
payments.
Cash surplus: The Cases end the year with a cash surplus of $11,336 (total income
of $73,040 minus total expenses of $61,704).

Chapter 2 | Developing Your Financial Statements and Plans

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

51

The Cases can use their surplus to increase savings, invest in stocks, bonds, or
other vehicles, or make payments on some outstanding debts. The best strategy
depends on their financial goals. If they had a cash deficit, the Cases would have to
withdraw savings, liquidate investments, or borrow an amount equal to the deficit to
meet their financial commitments (that is, to make ends meet). With their surplus
of $11,336, the Cases have made a positive contribution to their net worth.

Concept Check

LG4

2-5

What is an income and expense statement? What role does it serve in personal
financial planning?

2-6

Explain what cash basis means in this statement: An income and expense statement should be prepared on a cash basis. How and where are credit purchases
shown when statements are prepared on a cash basis?

2-7

Distinguish between fixed and variable expenses, and give examples of each.

2-8

Is it possible to have a cash deficit on an income and expense statement?


If so, how?

USING YOUR PERSONAL FINANCIAL STATEMENTS


Whether youre just starting out and have a minimal net worth or are further along
the path toward achieving your goals, your balance sheet and income and expense
statement provide insight into your current financial status. You now have the
information you need to examine your financial position, monitor your financial
activities, and track the progress youre making toward your financial goals. Lets
now look at ways to help you create better personal financial statements and analyze
them to better understand your financial situation.

Keeping Good Records


Although record keeping doesnt rank high on most to do lists, a good recordkeeping system helps you manage and control your personal financial affairs. With
organized, up-to-date financial records, youll prepare more accurate personal financial statements and budgets, pay less to your tax preparer, not miss any tax deductions, and save on taxes when you sell a house or securities or withdraw retirement
funds. Also, good records make it easier for a spouse or relative to manage your
financial affairs in an emergency. To that end, you should prepare a comprehensive
list of these records, their locations, and your key advisors (financial planner, banker,
accountant, attorney, doctors) for family members.
Prepare your personal financial statements at least once each year, ideally when
drawing up your budget. Many people update their financial statements every 3 or
6 months. You may want to keep a ledger, or financial record book, to summarize
all your financial transactions. The ledger has sections for assets, liabilities, sources
of income, and expenses; these sections contain separate accounts for each item.
Whenever any accounts change, make an appropriate ledger entry. For example, if
you bought an iPod for $250 in cash, youd show the iPod on your balance sheet as an
asset (at its fair market value) and as a $250 expenditure on your income and expense
statement. If you borrowed to pay for the iPod, the loan amount would be a liability
on the balance sheet, and any loan payments made during the period would be shown
on the income and expense statement. Youd keep similar records for asset sales, loan
repayments, income sources, and so on.

52

Part 1 | Foundations of Financial Planning

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

Exhibit 2.5

Organizing Your Financial Records

Confused about what to keep, where to keep it, and when to toss it? Here are some general rules.
Permanent papers: Place in a fireproof box (which wont protect documents from charring at high heat) or,
preferably, a safe-deposit box at the bank.
Birth, marriage, and death certificates; separation or divorce agreements; adoption papers; passports; military
service records; wills, health care proxy (giving someone legal right to make medical decisions if you become
incapacitated), powers of attorney; copies of IRAs and 401(k)s; all current insurance policies and the names of
the agents; securities certificates, deeds, and purchase and sale documents on all homes youve owned; other
documents relating to property ownership such as a car title; retirement fund records (pension plans, IRAs,
and so on) indicating which portions of them are tax deferred and therefore not subject to tax until funds are
withdrawn.
Keep original wills, proxies, and powers of attorney at home because a safe-deposit box may be sealed at your death.
Make copies of all other permanent papers to keep at home. Shred prior wills to avoid confusion.
Long-term papers: Keep for 7 years in a file cabinet or file boxes.
Federal and state income tax returns and all supporting documentation (receipts, charitable contributions, canceled
checks for tax-deductible expenses, casualty losses); household papers such as receipts, instruction manuals,
warranties, and records of home capital improvements.
After 7 years, transfer copies of tax returns to permanent storagedispose of supporting documentation by shredding.
Keep the following at least 3 years after the due date of the tax return in which you report the sale, the period the IRS
has to challenge your return: security purchase and sale confirmations, dividend reinvestment notices, and records
of stock splits; home-related documents.
Keep product warranties until they expire.
Short-term papers: Keep in a file cabinet or a file box at home.
Monthly bank, brokerage, mutual fund, 401(k) statements, paycheck stubs: Shred when you receive your yearend statement, and keep year-end statements for at least 3 years.
Credit card statements, utility, and telephone bills: Shred when paid.
ATM receipts and deposit slips: Shred when transaction appears on your bank statemewnt.
Other papers worth keeping: In case of emergency, you should have photos and fingerprints of your children. Medical
records are also good to keep.

Organizing Your Records


Your system doesnt have to be fancy to be effective. Youll need the ledger book
just described and a set of files with general categories such as banking and credit
cards, taxes, home, insurance, investments, and retirement accounts. An expandable
file, with a dozen or so compartments for incoming bills, receipts, paycheck stubs, or
anything you might need later, works well. You can easily keep a lot of this kind of
information in a computer spreadsheetbut if so, be sure to back it up from time to
time. Also, keep in mind that a bank safe-deposit box is a great place to store important documents and files.
Start by taking an inventory. Make a list of everything you own and owe. Check it
at least once a year to make sure its up-to-date and to review your financial progress.
Then, record transactions manually in your ledger or with financial planning software. Exhibit 2.5 offers general guidelines for keeping and organizing your personal
financial records.

Chapter 2 | Developing Your Financial Statements and Plans

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

53

Youll want to set up separate files for tax planning records, with one for income
(paycheck stubs, interest on savings accounts, and so on) and another for deductions,
as well as for individual mutual fund and brokerage account records. Once you set
up your files, be sure to go through them at least once a year and throw out unnecessary items.

Tracking Financial Progress: Ratio Analysis


Go to Smart Sites
Need help getting
organized? Youll find
advice for every area
of your life at the
Threadneedle Press site.

Each time you prepare your financial statements, you should analyze them to see how
well youre doing on your financial goals. For example, with an income and expense
statement, you can compare actual financial results with budgeted figures to make
sure that your spending is under control. Likewise, comparing a set of financial plans
with a balance sheet will reveal whether youre meeting your savings and investment
goals, reducing your debt, or building up a retirement reserve. You can compare current performance with historical performance to find out if your financial situation
is improving or getting worse.
Calculating certain financial ratios can help you evaluate your financial performance over time. Whats more, if you apply for a loan, the lender probably will look
at these ratios to judge your ability to carry additional debt. Four important money
management ratios are (1) solvency ratio, (2) liquidity ratio, (3) savings ratio, and (4)
debt service ratio. The first two are associated primarily with the balance sheet, the
last two with the income and expense statement. Exhibit 2.6 defines these ratios and
illustrates their calculation for Bob and Cathy Case.

Exhibit 2.6

Ratios for Personal Financial Statement Analysis

Ratio

Formula

2010 Calculation for the Cases

Solvency ratio

Total net worth


Total assets

$45,625
0.209, or 20.9%
$218,475

Liquidity ratio

Total liquid assets


Total current debts

$2,225
0.1268, or 12.68%
$17,545(a)

Savings ratio

Cash surplus
Income after taxes

$11,336
$11,336

0.197, or 19.7%
$73,040 $15,430 $57,610

Debt service ratio

Total monthly loan payments


Monthly gross (before-tax) income

$1,387(b)
0.204, or 20.4%
$6,807(c)

(a) Youll find the Cases total liquid assets ($2,225) and total current liabilities ($905) on Worksheet 2.1. The total
current debt totals $17,545: current liabilities of $905 (from Worksheet 2.1) plus loan payments due within 1 year
of $16,640 (from Worksheet 2.2). Note that loan payments due within 1 year consist of $11,820 in mortgage
payments, $2,520 in auto loan payments, $800 in furniture loan payments, $900 in education loan payments, and
$600 in loan payments to parents.
(b) On an annual basis, the Cases debt obligations total $16,640 ($11,820 in mortgage payments, $2,520 in auto
loan payments, $800 in furniture loan payments, $900 in education loan payments, and $600 in loan payments
to parents; all from Worksheet 2.2). The Cases total monthly loan payments are about $1,387 ($16,640 12
months).
(c) Dividing the Cases annual gross income (also found in Worksheet 2.2) of $73,040 by 12 equals $6,087 per month.

54

Part 1 | Foundations of Financial Planning

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

Balance Sheet Ratios


When evaluating your balance sheet, you should be most concerned with your
net worth at a given time. As explained earlier in this chapter, you are technically insolvent when your total liabilities exceed your total assetsthat is, when
solvency ratio
you have a negative net worth. The solvency ratio shows, as a percentage, your
Total net worth divided
degree of exposure to insolvency, or how much cushion you have as a protecby total assets; measures
tion against insolvency. Bob and Cathys solvency ratio is 20.9%, which means
the degree of exposure to
that they could withstand only about a 21% decline in the market value of their
insolvency.
assets before they would be insolvent. Consider that the stock market, as measured
by the S&P 500 index, fell about 37% during the financial crisis of 2008. Also,
the average homes value fell about 18% during that crisis year, as measured by
the S&P/Case-Shiller U.S. National Home Price Index. The low value of Bob and
Cathys solvency ratio suggests that they should consider improving it in the future
to better manage a potential decline in the value of their assets.
liquidity ratio
Although the solvency ratio indicates the potential to withstand financial probTotal liquid assets divided
lems, it does not deal directly with the ability to pay current debts. This issue is
by total current debts;
measures the ability to pay
addressed with the have liquidity ratio, which shows how long you could continue to
current debts.
pay current debts (any bills or charges that must be paid within 1 year) with existing
liquid assets in the event of income loss.
savings ratio
Cash surplus divided by
The calculated liquidity ratio indicates that the Cases can cover only about
net income (after tax);
13% of their existing 1-year debt obligations with their current liquid assets.
indicates relative amount
In other words, they have 1 months of coverage (a month is one-twelfth,
of cash surplus achieved
or 8.3%, of a year). If an unexpected event cut off their income, their liquid
during a given period.
reserves would quickly be exhausted. Although theres no hardFINANCIAL ROAD SIGN and-fast rule for what this ratio should be, it seems too low for
the Cases. They should consider strengthening it along with their
DECLUTTER YOUR LIFE!
solvency ratio. They should be able to add to their cash surpluses
now that Cathy is working full-time.
Too much paper in your house? Here
The amount of liquid reserves will vary with your personal cirare tips to eliminate what you dont
need.
cumstances and comfort level. Another useful liquidity guideline
is to have a reserve fund equal to 3 to 6 months of after-tax income
1. Be selective to avoid information
overload; you dont need to know
available to cover living expenses. The Cases after-tax income for
everything.
2010 was $4,801 per month ([$73,040 total income $15,430
2. Set up a regular weekly time to
income and Social Security taxes] 12). Therefore, this guideline
read the key materials you select.
suggests they should have between $14,403 and $28,806 in total liq3. Sort mail daily into a mail basket
uid assetsconsiderably more than the $2,225 on their latest balance
for each person, tossing obvious
sheet. If you feel that your job is secure or you have other potential
junk immediately.
sources of income, you may be comfortable with 3 or 4 months in
4. Dont procrastinate. Sort one pile
reserve. If you tend to be cautious financially, you may want to build
at a time and take some action
a larger fund. In troubled economic times, you may want to keep 6
now.
months or more of income in this fund as protection in case you lose
5. Dont make copies just in case.
your job.
6. File only the essentials. Eighty
percent of paper filed is rarely
used.

7. Purge files and other papers


regularly to make room for new
information.
8. Give away recent magazines,
catalogs, or books when theyre
still useful.
9. Buy a shredder and use it to shred
any paper with any personal identification and account numbers,
including unsolicited credit card
offers. This will minimize the risk of
identity theft.

Income and Expense Statement Ratios


When evaluating your income and expense statement, you should be
concerned with the bottom line, which shows the cash surplus (or
deficit) resulting from the periods activities. You can relate the cash
surplus (or deficit) to income by calculating a savings ratio, which is
done most effectively with after-tax income.
Bob and Cathy saved about 20% of their after-tax income, which is
on the high side (American families, on average, save about 5% to 8%).
How much to save is a personal choice. Some families would plan much
higher levels, particularly if theyre saving to achieve an important goal,
such as buying a home.
Although maintaining an adequate level of savings is obviously
important to personal financial planning, so is the ability to pay debts

Chapter 2 | Developing Your Financial Statements and Plans

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

55

debt service ratio


Total monthly loan
payments divided by
monthly gross (before-tax)
income; provides a measure
of the ability to pay debts
promptly.

promptly. In fact, debt payments have a higher priority. The debt service ratio
allows you to make sure you can comfortably meet your debt obligations. This ratio
excludes current liabilities and considers only mortgage, installment, and personal
loan obligations.
Monthly loan payments account for about 20% of Bob and Cathys monthly
gross income. This relatively low debt service ratio indicates that the Cases
should have little difficulty in meeting their monthly loan payments. In your
financial planning, try to keep your debt service ratio somewhere under 35%
or so, because thats generally viewed as a manageable level of debt. Of course,
the lower the debt service ratio, the easier it is to meet loan payments as they
come due.

Concept Check
2-9
2-10

LG5

How can accurate records and control procedures be used to ensure the effectiveness of the personal financial planning process?
Describe some of the areas or items you would consider when evaluating your
balance sheet and income and expense statement. Cite several ratios that could
help in this effort.

CASH IN AND CASH OUT: PREPARING


AND USING BUDGETS
Many of us avoid budgeting as if it were the plague. After all, do you really want to
know that 30% of your take-home pay is going to restaurant meals? Yet preparing,
analyzing, and monitoring your personal budget are essential steps for successful
personal financial planning.
After defining your short-term financial goals, you can prepare a cash budget for the coming year. Recall that a budget is a short-term financial planning
report that helps you achieve your short-term financial goals. By taking the time
to evaluate your current financial situation, spending patterns, and goals, you can
develop a realistic budget that is consistent with your personal lifestyle, family
situation, and values. A cash budget is a valuable money management tool that
helps you:
1. Maintain the necessary information to monitor and control your finances
2. Decide how to allocate your income to reach your financial goals
3. Implement a system of disciplined spendingas opposed to just existing from one
paycheck to the next
4. Reduce needless spending so you can increase the funds allocated to savings and
investments
5. Achieve your long-term financial goals
Just as your goals will change over your lifetime, so too will your budget as
your financial situation becomes more complex. Typically, the number of income
and expense categories increases as you accumulate more assets and debts and have
more family responsibilities. For example, the budget of a college student should be
quite simple, with limited income from part-time jobs, parental contributions, and
scholarships and grants. Expenses might include room and board, clothes, books,
auto expenses, and entertainment. Once a student graduates and goes to work fulltime, his or her budget will include additional expenses such as rent, insurance, work
clothes, and commuting costs. For most people this process does not become simpler
until retirement.

56

Part 1 | Foundations of Financial Planning

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

FINANCIAL ROAD SIGN


DEVELOPING A BUDGET
A budget may sound restrictive and no fun at all, but it is the path to successful financial planning. How can you get
where you want to go if you dont know where you are from month to month? A few simple steps will get you started.
1. Collect your receipts for all expenditures over the last three months. This should include everything: rent or mortgage,
utilities, car, gas, insurance, and personal things like dinners out. Organize the expenditures by month.
2. Categorize each of the expenditures as flexible or fixed. Fixed expenditures dont change from month to month
whereas flexible expenditures do. Fixed expenditures typically include rent, utilities, and car payments. Flexible expenditures usually include groceries, and personal purchases. If you are having trouble balancing your budget, flexible
expenditures provide some room to maneuver.
3. Collect records of all of the money you earned during the same period of time. This should include your salary, any extra
money made beyond your usual job, and anything that provided you with extra cash.
4. Add up all of your expenditures and all of your income in each of the three months.
5. Take a hard look at your flexible expenses because thats where you can bridge the difference between your expenditures and income. Excellent starting places are credit cards, personal expenditures like dinners out, and grocery bills.
Balance can be achieved.
Source: Adapted from Robert Vaux, How to Develop a Budget Plan, http://www.ehow.com/how_4797954_develop-budget-plan.html, accessed
April 2009.

The Budgeting Process


cash budget
A budget that takes into
account estimated monthly
cash receipts and cash
expenses for the coming
year.

Like the income and expense statement, a budget should be prepared on a cash
basis; thus, we call this document a cash budget because it deals with estimated cash
receipts and cash expenses, including savings and investments, that are expected to
occur in the coming year. Because you receive and pay most bills monthly, youll
probably want to estimate income as well as expenses on a monthly basis.
The cash budget preparation process has three stages: estimating income, estimating expenses, and finalizing the cash budget. When youre estimating income
and expenses, take into account any anticipated changes in the cost of living and
their impact on your budget components. If your income is fixednot expected
to change over the budgetary periodthen increases in various expense items
will probably decrease the purchasing power of your income. Worksheet 2.3, the
Cases Annual Cash Budget by Month, has separate sections to record income
(cash receipts) and expenses (cash expenses) and lists the most common categories
for each.

Estimating Income
The first step in preparing your cash budget is to estimate your income for the coming
year. Include all income expected for the year: the take-home pay of both spouses,
expected bonuses or commissions, pension or annuity income, and investment
incomeinterest, dividend, rental, and asset (particularly security) sale income. When
estimating income, keep in mind that any amount you receive for which repayment
is required is not considered income. For instance, loan proceeds are treated not as a
source of income but as a liability for which scheduled repayments are required.
Unlike the income and expense statement, in the cash budget you should use
take-home pay (rather than gross income). Your cash budget focuses on those areas
that you can controland most people have limited control over things like taxes
withheld, contributions to company insurance and pension plans, and the like. In
effect, take-home pay represents the amount of disposable income you receive from
your employer.

Chapter 2 | Developing Your Financial Statements and Plans

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

57

Worksheet 2.3

The Cases Annual Cash Budget by Month

The Cases annual cash budget shows several months in which substantial cash deficits are expected to occur; they
can use this information to develop plans for covering those monthly shortfalls.

ANNUAL CASH BUDGET BY MONTH

Bob and Cathy Case


Name(s)
For the Year

INCOME

Jan.

Ended

Feb.

Mar.

April

May

June

July

Aug.

Sep.

Oct.

December 31, 2011

Nov.

Dec.

Total for
the Year

$ 4,775 $ 4,775 $ 4,775 $ 4,965 $ 4,965 $ 5,140 $ 5,140 $ 5,140 $ 5,140 $ 5,140 $ 5,140 $ 5,140 $ 60,235
Take-home pay
Bonuses and commissions
1,350
1,300
2,650
Pensions and annuities
Investment income
50
50
50
50
200
Other income
(I) Total Income $ 4,775 $ 4,775 $ 4,825 $ 4,965 $ 4,965 $ 6,540 $ 5,140 $ 5,140 $ 5,190 $ 5,140 $ 5,140 $ 6,490 $ 63,085

EXPENSES
Housing (rent/mtge., repairs)
$ 1,185 $ 1,485 $ 1,185 $ 1,185 $ 1,185 $ 1,185 $ 1,185 $ 1,185 $ 1,185 $ 1,185 $ 1,185 $ 1,185 $ 14,520
Utilities (phone, elec., gas, water)
245
245
245
175
180
205
230
245
205
195
230
250
2,650
Food (home and away)
696
696
696
696
696
696
696
696
696
696
696
696
8,352
Transportation (auto/public)
370
620
370
355
370
370
575
370
370
450
370
370
4,960
Medical/dental, incl. insurance
30
30
30
30
30
45
30
30
30
30
30
30
375
Clothing
150
150
470
200
200
200
300
500
200
300
300
300
3,270
Insurance (life, auto, home)
660
1,598
660
1,598
4,516
Taxes (property)
550
550
1,100
Appliances, furniture, and other
(purchases/loans)
60
60
60
60
60
60
60
60
60
60
60
60
720
Personal care
100
100
100
100
100
100
100
100
100
100
100
100
1,200
Recreation and entertainment
250
300
3,200
200
200
300
300
200
200
200
200
2,050
7,600
Savings and investments
575
575
575
575
575
575
575
575
575
575
575
575
6,900
Other expenses
135
250
235
135
410
180
135
285
245
135
605
385
3,135
Fun money
230
230
230
130
230
230
230
230
230
230
230
230
2,660
(II) Total Expenses $ 4,026 $ 5,291 $ 7,396 $ 4,501 $ 5,834 $ 4,146 $ 4,416 $ 5,026 $ 4,096 $ 4,816 $ 6,179 $ 6,231 $ 61,958
CASH SURPLUS (OR DEFICIT) [(I)-(II)]

749 $ (516) $(2,571) $

CUMULATIVE CASH SURPLUS (OR DEFICIT)

749 $

464 $ (869) $ 2,394 $

724 $

114 $ 1,094 $

324 $(1,039) $

233 $(2,338) $(1,874) $(2,743) $ (349) $

375 $

489 $ 1,583 $ 1,907 $

259 $

1,127

868 $ 1,127 $

1,127

Estimating Expenses
The second step in the cash budgeting process is by far the most difficult: preparing
a schedule of estimated expenses for the coming year. This is usually done using
actual expenses from previous years (as found on income and expense statements
and in supporting information for those periods), along with predetermined shortterm financial goals. Good financial records, as discussed earlier, make it easier
to develop realistic expense estimates. If you do not have past expense data, you
could reexamine old checkbook registers and credit card statements to approximate expenses, or take a needs approach and attach dollar values to projected
expenses. Pay close attention to expenses associated with medical disabilities,
divorce and child support, and similar special circumstances.
Whether or not you have historical information, when preparing your budget be
aware of your expenditure patterns and how you spend money. After tracking your
expenses over several months, study your spending habits to see if you are doing
things that should be eliminated. For example, you may become aware that you are
going to the ATM too often or using credit cards too freely.

58

Part 1 | Foundations of Financial Planning

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

Go to Smart Sites
Link to a Family Budget
Calculator to compare
how budgets vary by
family type and area of the
country.

Youll probably find it easier to budget expenses if you group them into several
general categories rather than trying to estimate each item. Worksheet 2.3 is an
example of one such grouping scheme, patterned after the categories used in the
income and expense statement. You may also want to refer to the average expense
percentages given in Exhibit 2.3. Choose categories that reflect your priorities and
allow you to monitor areas of concern.
Your expense estimates should include the transactions necessary to achieve your
short-term goals. You should also quantify any current or short-term contributions
toward your long-term goals and schedule them into the budget. Equally important
are scheduled additions to savings and investments, because planned savings should
be high on everyones list of goals. If your budget doesnt balance with all these items,
you will have to make some adjustments in the final budget.
Base estimated expenses on current price levels and then increase them by a
percentage that reflects the anticipated rate of inflation. For example, if you estimate the current monthly food bill at $500 and expect 4% inflation next year,
you should budget your monthly food expenditure next year at $520, or $500
$20 (4% $500).
Dont forget an allowance for fun money, which family members can spend
as they wish. This gives each person some financial independence and helps form a
healthy family budget relationship.

Finalizing the Cash Budget


After estimating income and expenses, finalize your budget by comparing projected
income to projected expenses. Show the difference in the third section as a surplus
or deficit. In a balanced budget, the total income for the year equals or exceeds total
expenses. If you find that you have a deficit at year end, youll have to go back and
adjust your expenses. If you have several months of large surpluses, you should be
able to cover any shortfall in a later month, as explained later. Budget preparation is
complete once all monthly deficits are resolved and the total annual budget balances.
Admittedly, theres a lot of number crunching in personal cash budgeting. As discussed earlier, personal financial planning software can greatly streamline the budget
preparation process.

Dealing with Deficits


Even if the annual budget balances, in certain months expenses may exceed income,
causing a monthly budget deficit. Likewise, a budget surplus occurs when income in
some months exceeds expenses. Two remedies exist:

Shift expenses from months with budget deficits to months with surpluses (or,
alternatively, transfer income, if possible, from months with surpluses to those
with deficits).
Use savings, investments, or borrowing to cover temporary deficits.

Because the budget balances for the year, the need for funds to cover shortages is only
temporary. In months with budget surpluses, you should return funds taken from savings or investments or repay loans. Either remedy is feasible for curing a monthly budget
deficit in a balanced annual budget, although the second is probably more practical.
What can you do if your budget shows an annual budget deficit even after youve
made a few expense adjustments? You have three options, as follows.

Liquidate enough savings and investments or borrow enough to meet the total budget shortfall for the year. Obviously, this option is not preferred, because it violates
the objective of budgeting: to set expenses at a level that allows you to enjoy a
reasonable standard of living and progress toward achieving your long-term goals.
Reducing savings and investments or increasing debt to balance the budget reduces
net worth. People who use this approach are not living within their means.

Chapter 2 | Developing Your Financial Statements and Plans

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

59

Go to Smart Sites

Find links to a variety of


money-saving resources at
About Inc.

Cut low-priority expenses from the budget. This option is clearly preferable to
the first one. It balances the budget without using external funding sources by
eliminating expenses associated with your least important short-term goals, such
as flexible or discretionary expenses for nonessential items (e.g., recreation, entertainment, some types of clothing). This chapters Money in Action feature can
help you find easy ways to spend less.
Increase income. Finding a higher-paying job or perhaps a second, part-time job
is the most difficult option; it takes more planning and may result in significant
lifestyle changes. However, people who cant liquidate savings or investments or
borrow funds to cover necessary expenses may have to choose this route to balance their budgets.

A Cash Budget for Bob and Cathy Case


Using their short-term financial goals (Worksheet 1.1 in Chapter 1) and past financial
statements (Worksheets 2.1 and 2.2), Bob and Cathy Case have prepared their cash
budget for the 2011 calendar year. Worksheet 2.3 shows the Cases estimated total
2011 annual income and expenses by month as well as their monthly and annual cash
surplus or deficit.
The Cases list their total 2011 income of $63,085 by source for each month. By
using take-home pay, they eliminate the need to show income-based taxes, Social
Security payments, and other payroll deductions as expenses. The take-home pay
reflects Bobs and Cathys expected salary increases.
In estimating annual expenses for 2011, the Cases anticipate a small amount of
inflation and have factored some price increases into their expense projections. They
have also allocated $6,900 to savings and investments, a wise budgeting strategy, and
included an amount for fun money to be divided between them.
During their budgeting session, Bob and Cathy discovered that their first estimate
resulted in expenses of $63,299, compared with their estimated income of $63,085.
To eliminate the $214 deficit to balance their budget and allow for unexpected
expenses, Bob and Cathy made these decisions:

Omit some low-priority goals: spend less on stereo components, take a shorter
Hawaiian vacation instead of the Colorado ski trip shown in Worksheet 1.1.
Reschedule some of the loan repayment to their parents.
Reduce their fun money slightly.

IMAGE SOURCE BLACK (RF)/JUPITER IMAGES

These reductions lower Bob and Cathys total


scheduled expenses to $61,958, giving them a surplus of $1,127 ($63,085 $61,958) and more than
balancing the budget on an annual basis. Of course,
the Cases can reduce other discretionary expenses to
further increase the budget surplus and have a cushion for unexpected expenses.
The Cases final step is to analyze monthly surpluses and deficits and determine whether to use
savings, investments, or borrowing to cover monthly
shortfalls. The bottom line of their annual cash budget lists the cumulative, or running, totals of monthly
cash surpluses and deficits. Despite their $1,127
year-end cumulative cash surplus, they have cumulative deficits in March, April, May, and June primarily because of their March Hawaiian vacation and insurance payments. To help
cover these deficits, Bob and Cathy have arranged an interest-free loan from their
parents. If they had dipped into savings to finance the deficits, they would have
lost some interest earnings, which are included as income. They could delay clothing and recreation and entertainment expenses until later in the year to reduce the

60

Part 1 | Foundations of Financial Planning

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

Money in Action
SMALL WAYS TO
SAVE BIG!
Seemingly small expenditures really
add up over time. If you can plug
these small-time drains, you can
increase the amount available to
save and invest. So what are some
of the small expenditures that can
be eliminated without much pain?
Here are some places to start.
1. Enroll in a 401(k). Many
employers match up to 50%
of what you contribute. So
putting in another $50 a
month will generate over
$1,000 in retirement investments over a year. And taxes
are deferred on the contributions, which will reduce the
amount taken by taxes out of
each paycheck. Consider an
increase in your contribution
of $100 a month when you
have 25 years until retirement.
If you earn 6% on the investments, you will increase your
wealth at retirement by almost
$70,000!
2. Raise your car insurance
deductible. Consider sharing
more of the risk by increasing
your deductible from $250 to
$1,000, which can reduce your
premium by at least 15%.
3. Pay off your credit card.
Carrying a $1,000 balance
at 1.5% a month costs you
annual interest of almost
$200.
4. Reduce energy costs.
Programmable thermostats
can be bought for as little as
$50, yet they can reduce your
heating-and-cooling bill by
10% to 20%.

5. Telecommunications bundling. Obtaining your phone,


Internet connection, and TV
signal from one provider can
reduce your bill by $50 a
month.
6. Take advantage of your
employers Flexible Spending
Account (FSA). FSAs allow
you to pay health care
costs with pre-tax dollars.
Depending on your tax rate,
this can save you 33% or
more.
7. Use a credit card with
rewards. If you charge $100
a week on things like gas and
groceries, a 5% cash rebate
on a credit card will save you
about $260 a year.
8. Bring your lunch to work. If
you can make a lunch for $3
cheaper than buying itand
who cant?youll save $60 a
month or $720 a year.
9. Negotiate your credit card
rate. While its certainly not
advertised, some credit card
issuers will give cardholders
with good credit a lower rate
than the usual 18% APR. Its
best to call with examples of
offers made by other credit
card companies in hand.
10. Get the best travel deals. Rely
on travel search engines like
http://www.sidestep.com/

and http://www.kayak.com,
which search a number of
travel sites for you.
11. Remember the library? Find
that old library card and
check out DVDs and books
for free. Lets say you usually
buy a book a month and rent

a movie once a week. Your


library card could save you
$30 a month!
12. Go for the best-fitting calling
plan. The average wireless
phone plan costs about $60
a month. If you use 200 or
fewer minutes per month,
changing to a prepaid plan
that costs 25 cents a minute
could save you $10 a month.
13. Use or lose your gym. A gym
membership can be a great
investmentif you actually
work out. So forking over $40
a month or $500 a year for a
gym membership might make
great sense. But if you dont
use it, lose it. If you do work
out, its still a good idea to
find out if there are community centers in your area. Some
are free or charge a modest fee
like $100 a year.
14. Shop around for car insurance. Find out if youre getting
the best deal using a comparison site like http://www
.insweb.com.

15. Keep track of your money.


As discussed in this chapter,
it is essential to know what
you spend in order to identify
where you can economize.
This will help you achieve
your savings goals.
Critical Thinking Questions
1. List three small savings you can
make, and show how theyll
grow over time.
2. How can opening a 401(k) plan
save you money?

Source: Adapted from Jessica Anderson, 20 Small Ways to Save Big, March 1, 2007, http://www.kiplinger.com/features/archives/2007/02/
savebig.html?kipad_id43, accessed April 2009.

Chapter 2 | Developing Your Financial Statements and Plans

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

61

deficits more quickly. If they werent able to obtain funds to cover the deficits, they
would have to reduce expenses further or increase income. At year end, they should
use their surplus to increase savings or investments or to repay part of a loan.

Using Your Budgets

budget control
schedule
A summary that shows
how actual income and
expenses compare with the
various budget categories
and where variances
(surpluses or deficits) exist.

Go to Smart Sites
Get more budgeting
advice from CNNMoneys
budgeting tutorial by
clicking on Evaluating
them for an interactive
budget worksheet.

In the final analysis, a cash budget has value only if (1) you use it and (2) you
keep careful records of actual income and expenses. These records show whether
you are staying within your budget limits. Record this information in a budget
record book or an Excel spreadsheet often enough that you dont overlook anything significant, yet not so often that it becomes a nuisance. A loose-leaf binder
with separate pages for each income and expense category works quite well. So
does a well-organized spreadsheet. Rounding entries to the nearest dollar simplifies the arithmetic.
At the beginning of each month, record the budgeted amount for each category
and enter income received and money spent on the appropriate pages. At months
end, total each account and calculate the surplus or deficit. Except for certain
income accounts (such as salary) and fixed expense accounts (such as mortgage
or loan payments), most categories will end the month with a positive or negative
variance, indicating a cash surplus or deficit. You can then transfer your total
spending by category to a budget control schedule that compares actual income
and expenses with the various budget categories and shows the variances.
This monthly comparison makes it easy to identify major budget categories
where income falls far short ofor spending far exceedsdesired levels (variances of 5% to 10% or more). After pinpointing these areas, you can take
corrective action to keep your budget on course. Dont just look at the size of
the variances. Analyze them, particularly the larger ones, to discover why they
occurred. An account deficit that occurs in only one period is obviously less of a
problem than one that occurs in several periods. If recurring deficits indicate that
an account was underbudgeted, you may need to adjust the budget to cover the
outlays, reducing over-budgeted or nonessential accounts. Only in exceptional
situations should you finance budget adjustments by using savings and investments or by borrowing.
Looking at the Cases budget control schedule for January, February, and
March 2011 on Worksheet 2.4, you can see that actual income and expense levels
are reasonably close to their targets and have a positive variance for the months
shown (their surpluses exceed the budgeted surplus amounts). The biggest variances
were in food and transportation expenses, but neither was far off the mark. Thus,
for the first 3 months of the year, the Cases seem to be doing a good job of controlling their income and expenses. In fact, by cutting discretionary spending they have
achieved a cumulative cash surplus of $419 for the year-to-date variance.

Concept Check

62

2-11

Describe the cash budget and its three parts. How does a budget deficit differ
from a budget surplus?

2-12

The McDonald family has prepared their annual cash budget for 2011. They
have divided it into 12 monthly budgets. Although only one monthly budget
balances, they have managed to balance the overall budget for the year. What
remedies are available to the McDonald family for meeting the monthly budget
deficits?

2-13

Why is it important to analyze actual budget surpluses or deficits at the end of


each month?

Part 1 | Foundations of Financial Planning

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

Worksheet 2.4

The Cases Budget Control Schedule for January, February, and March 2011

The budget control schedule provides important feedback on how the actual cash flow is stacking up relative to the
forecasted cash budget. If the variances are significant enough and/or continue month after month, the Cases should
consider altering either their spending habits or their cash budget.

BUDGET CONTROL SCHEDULE

Bob and Cathy Case


Name(s)
3
For the

INCOME
Take-home pay
Bonuses and commissions
Pensions and annuities
Investment income
Other income
(I) Total Income

March 31, 2011

Months Ended

Month:

January

Budgeted
Amount
(1)

Monthly Year-to-Date Budgeted


Variance
Variance
Amount
(3)
(4)
(5)

Actual
(2)

$4,775 $ 4,792 $

Month:

17 $
0
0

$4,775 $ 4,792 $

17

$4,775

February
Actual
(6)

Month:

Monthly Year-to-Date
Variance
Variance
(7)
(8)

$4,792 $

17 $

34

March

Budgeted
Amount
(9)

Monthly Year-to-Date
Variance
Variance
(11)
(12)

Actual
(10)

$ 4,775 $ 4,792 $

17 $

51

0
0

17 $

0
0
50

46

(4)

(4)
0

17

$4,775

$4,792 $

17 $

34

$ 4,825 $ 4,838 $

13 $

47

EXPENSES
Housing (rent/mtge., repairs)
Utilities (phone, elec., gas, water)
Food (home and away)
Transportation (auto/public)
Medical/dental, incl. insurance
Clothing
Insurance (life, auto, home)
Taxes (property)
Appliances, furniture, and other
(purchases/loans)
Personal care
Recreation and entertainment

1,185

1,185

1,485

1,485

1,185

1,185

245

237

(8)

(8)

245

252

(1)

245

228

(17)

(18)
(168)

696

680

(16)

(16)

696

669

(27)

(43)

696

571

(125)

370

385

15

15

620

601

(19)

(4)

370

310

(60)

(64)

30

(30)

(30)

30

45

15

(15)

30

(30)

(45)

150

190

40

40

150

135

(15)

25

470

445

(25)

550

550

0
(15)
(40)

0
(15)
(40)

60
100
300

60
120
290

0
20
(10)

0
5
(50)

60
100
3,200

60
75
3,285

0
(25)
85

0
(20)
35

0
(17)
(30)
(101)

575
250
230
$5,291

575
245
225
$5,252 $

0
(5)
(5)
(39) $

0
(22)
(35)
(140)

118 $

118

$ (516)

$(460) $

56 $

174

$(2,571)$(2,326) $

118

$ 233

$ 407

174

$(2,338) $(1,919)

60
100
250

60
85
210

Savings and investments


Other expenses
Fun money
(II) Total Expenses

575
575
0
135
118
(17)
230
200
(30)
$4,026 $ 3,925 $ (101) $

CASH SURPLUS (OR DEFICIT) [(I)  (II)]

$ 749 $

867 $

CUMULATIVE CASH SURPLUS


(OR DEFICIT)

$ 749 $

867

575
575
0
235
200
(35)
230
230
0
$ 7,396 $ 7,164 $ (232) $

0
(57)
(35)
(372)

0
245 $

0
419

419

Key: Col. (3) = Col. (2) Col. (1); Col. (7) = Col. (6) Col. (5); Col. (11) = Col. (10) Col. (9); Col. (4) = Col. (3); Col. (8) = Col. (4) + Col. (7); Col. (12) = Col. (8) + Col. (11).

LG6

THE TIME VALUE OF MONEY: PUTTING A DOLLAR


VALUE ON FINANCIAL GOALS
Assume that one of your financial goals is to buy your first home in 6 years. Then your
first question is how much do you want to spend on that home. Lets say youve done
some window shopping and feel that, taking future inflation into consideration, you
can buy a nice condominium for about $200,000 in 6 years. Of course, you wont need
the full amount, but assuming that youll make a 20% down payment of $40,000 (0.20
$200,000 $40,000) and pay $5,000 in closing costs, youll need $45,000. You now
have a fairly well-defined long-term financial goal: To accumulate $45,000 in 6 years to
buy a home costing about $200,000.
The next question is how to get all that money. Youll probably accumulate it by
saving or investing a set amount each month or year. You can easily estimate how
much to save or invest each year if you know your goal and what you expect to earn

Chapter 2 | Developing Your Financial Statements and Plans

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

63

TIMELINE
I = 5%

$105

0
0
$100

End of Year

TIMELINE
I = 5%
0

5
6
$6,700

$5,000

End of Year

CALCULATOR
INPUTS
5000
6
5

FUNCTIONS
PV
N
I
CPT
FV
SOLUTION
6,700.48

See Appendix E for details.

time value of money


The concept that a dollar
today is worth more than
a dollar received in the
future.

timeline
A graphical presentation of
cash flows.

future value
The value to which an
amount today will grow
if it earns a specific rate
of interest over a given
period.

compounding
When interest earned each
year is left in an account
and becomes part of the
balance (or principal) on
which interest is earned in
subsequent years.

on your savings or investments. In this case, if you have to start from scratch (that
is, if nothing has already been saved) and estimate that you can earn about 5% on
your money, youll have to save or invest about $6,616 per year for each of the next
6 years to accumulate $45,000 over that time. Now you have another vital piece
of information: You know what you must do over the next 6 years to reach your
financial goal.
How did we arrive at the $6,616 figure? We used a concept called the
time value of money, the idea that a dollar today is worth more than a dollar received
in the future. With time value concepts, we can correctly compare dollar values
occurring at different points in time. As long as you can earn a positive rate of return
(interest rate) on your investments (ignoring taxes and other behavioral factors), in
a strict financial sense you should always prefer to receive equal amounts of money
sooner rather than later. The two key time value concepts, future value and present
value, are discussed separately next. Well use timelines, graphical representations of
cash flows, to visually depict the time value calculations. They will appear in the text
margin near the related discussion. (Note: The time value discussions and demonstrations initially rely on the use of financial tables. Appendix E explains how to use
financial calculators, which have tables built into them, to conveniently make time
value calculations.) The calculator keystrokes for each calculation are shown in the
text margin near the related discussion. Because of rounding in the tables, the calculator values will always be more precise.

Future Value
To calculate how much to save to buy the $200,000 condominium, we used
future value, the value to which an amount today will grow if it earns a specific
rate of interest over a given period. Assume, for example, that you make annual
deposits of $2,000 into a savings account that pays 5% interest per year. At the
end of 20 years, your deposits would total $40,000 (20 $2,000). If you made no
withdrawals, your account balance would have increased to $66,132! This growth in
value occurs not only because of earning interest but also because of compounding
the interest earned each year is left in the account and becomes part of the balance
(or principal) on which interest is earned in subsequent years.

Future Value of a Single Amount


To demonstrate future value, lets return to the goal of accumulating $45,000 for a
down payment to buy a home in 6 years. You might be tempted to solve this problem by simply dividing the $45,000 goal by the 6-year period: $45,000/6 $7,500.
This procedure would be incorrect, however, because it fails to take into account
the time value of money. The correct way to approach this problem is to use the
future value concept. For instance, if you can invest $100 today at 5%, you will
have $105 in a year. You will earn $5 on your investment (0.05 $100 $5) and
get your original $100 back. Once you know the length of time and rate of return
involved, you can find the future value of any investment by using the following
simple formula:
Future value  Amount invested  Future value factor
Tables of future value factors simplify the computations in this formula (see
Appendix A). The table is easy to use; simply find the factor that corresponds to a
given year and interest rate. Referring to Appendix A, you will find the future value
factor for a 6-year investment earning 5% is 1.340 (the factor that lies at the intersection of 6 years and 5%).
Returning to the problem at hand, lets say you already have accumulated $5,000
toward the purchase of a new home. To find the future value of that investment in
6 years earning 5%, you can use the preceding formula as follows:
Future value  $5,000  1.340  $6,700

64

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annuity
A fixed sum of money that
occurs annually.

In 6 years, then, you will have $6,700 if you invest the $5,000 at 5%. Because you
feel you are going to need $45,000, you are still $38,300 short of your goal.

TIMELINE Future Value of an Annuity


I = 5%
1

$5,631

$5,631

$38,300

$5,631

$5,631

$5,631

$5,631

End of Year

CALCULATOR
INPUTS
38,300
6
5

FUNCTIONS
FV
N
I
CPT
PMT
SOLUTION
5,630.77

TIMELINE
0

$6,616

$45,000

$6,616
$6,616

$6,616
$6,616

$6,616

End of Year

CALCULATOR
INPUTS
45000
6
5

Amount of money desired


Yearly savings  ________________________
Future value annuity factor
When dealing with an annuity you need to use a different table of factors, such
as that in Appendix B. Note that its very much like the table of future value factors
and, in fact, is used in exactly the same way: the proper future value annuity factor is
the one that corresponds to a given year and interest rate. For example, youll find in
Appendix B that the future value annuity factor for 6 years and 5% is 6.802. Using
this factor in the previous equation, you can find out how much to save each year to
accumulate $38,300 in 6 years, given a 5% rate of return, as follows:

See Appendix E for details.

I = 5%

How are you going to accumulate the additional $38,300? Youll again use the future
value concept, but this time youll use the future value annuity factor. An annuity
is a fixed sum of money that occurs annually; for example, a deposit of $1,000 per
year for each of the next 5 years, with payment to be made at the end of each year.
To find out how much you need to save each year in order to accumulate a given
amount, use this equation:

FUNCTIONS
FV
N
I
CPT
PMT
SOLUTION
6,615.79

See Appendix E for details.

Go to Smart Sites
Check out this chapters
online resources for
another lesson on time
value concepts.

rule of 72
A useful formula for
estimating about how long
it will take to double a sum
at a given interest rate.

$38,300
Yearly savings  ________  $5,630.70
6.802
Youll need to save about $5,630.70 a year to reach your goal. Note in this example that you must add $5,630.70 each year to the $5,000 you initially invested in
order to build up a pool of $45,000 in 6 years. At a 5% rate of return, the $5,630.70
per year will grow to $38,300 and the $5,000 will grow to $6,700, so in 6 years
youll have $38,300 $6,700 $45,000.
How much, you may ask, would you need to save each year if you didnt have the
$5,000 to start with? In this case, your goal would still be the same (to accumulate
$45,000 in 6 years), but because youd be starting from scratch, the full $45,000
would need to come from yearly savings. Assuming you can still earn 5% over the
6-year period, you can use the same future value annuity factor (6.802) and compute
the amount of yearly savings as follows:
$45,000
Yearly savings  ________  $6,615.70
6.802
or approximately $6,616. Note that this amount corresponds to the $6,616 figure
cited at the beginning of this section.
Using the future value concept, you can readily find either the future value to
which an investment will grow over time or the amount that you must save each year
to accumulate a given amount of money by a specified future date. In either case, the
procedures allow you to put monetary values on long-term financial goals.

The Rule of 72
Suppose that you dont have access to time value of money tables or a financial calculator but want to know how long it takes for your money to double. Theres an
easy way to approximate this using the rule of 72. Simply divide the number 72 by
the percentage rate youre earning on your investment:
72
Number of years to double money  ____________________________
Annual compound interest rate

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65

TIMELINE
I = 5%
1

$300,000

...

24

25

$88,500

End of Year

CALCULATOR
INPUTS
300000
25
5

FUNCTIONS
FV
N
I
CPT
PV
SOLUTION
88,590.83

See Appendix E for details.

Lucky you! Youve just won $100,000 in your state lottery. You want to spend part
of it now, but because youre 30 years old, you also want to use part of it for your
retirement fund. Your goal is to accumulate $300,000 in the fund by the time youre
age 55 (25 years from now). How much do you need to invest if you estimate that
you can earn 5% annually on your investments during the next 25 years?
Using present value, the value today of an amount to be received in the future,
you can calculate the answer. It represents the amount youd have to invest today at
a given interest rate over the specified time period to accumulate the future amount.
The process of finding present value is called discounting, which is the inverse of
compounding to find future value.

present value

Present Value of a Single Amount


Assuming you wish to create the retirement fund (future value) by making a single
lump-sum deposit today, you can use this formula to find the amount you need to
deposit:

The process of finding


present value; the inverse
of compounding to find
future value.

TIMELINE
I = 5%

$300,000

Present Value

The value today of an


amount to be received
in the future; its the
amount that would have
to be invested today at a
given interest rate over
a specified time period
to accumulate the future
amount.

discounting

For example, assume that you recently opened a savings account with $1,000 that
earns an annual compound rate of interest of 4.5%. Your money will double in 16
years (72 4.5 16). On the other hand, if you can find a $1,000 investment that
earns 6.25%, youll have $2,000 in about 11.5 years (72 6.25 11.5).
The rule of 72 also applies to debts. Your debts can quickly double with high
interest rates, such as those charged on most credit card accounts. So keep the rule of
72 in mind whether you invest or borrow!

...

$19,515

29 30
$19,515

$19,515

$19,515

End of Year

CALCULATOR
INPUTS
300000
30
5

FUNCTIONS
PV
N
I
CPT
PMT
SOLUTION
19,515.43

See Appendix E for details.

Present value  Future value  Present value factor


Tables of present value factors make this calculation easy (see Appendix C). First,
find the present value factor for a 25-year investment at a 5% discount rate (the factor that lies at the intersection of 25 years and 5%) in Appendix C; it is 0.295. Then,
substitute the future value of $300,000 and the present value factor of 0.295 into the
formula as follows:
Present value  $300,000  0.295  $88,500
The $88,500 is the amount youd have to deposit today into an account paying 5%
annual interest in order to accumulate $300,000 at the end of 25 years.

Present Value of an Annuity


You can also use present value techniques to determine how much you can withdraw
from your retirement fund each year over a specified time horizon. This calls for the
present value annuity factor. Assume that at age 55 you wish to begin making equal
annual withdrawals over the next 30 years from your $300,000 retirement fund. At
first, you might think you could withdraw $10,000 per year ($300,000/30 years).
However, the funds still on deposit would continue to earn 5% annual interest. To
find the amount of the equal annual withdrawal, you again need to consider the time
value of money. Specifically, you would use this formula:
Initial deposit
Annual withdrawal  _________________________
Present value annuity factor
Use the present value annuity factors in Appendix D for this calculation. Substituting
the $300,000 initial deposit and the present value annuity factor for 30 years and 5%
of 15.373 (from Appendix D) into the preceding equation, we get
$300,000  $19,514.73
Annual withdrawal  _________
15.373

66

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Therefore, you can withdraw $19,514.73 each year for 30 years. This value is clearly
much larger than the $10,000 annual withdrawal mentioned earlier.

Other Applications of Present Value

TIMELINE
I = 5%
$700

$700

$700

$700

$700

You can also use present value techniques to analyze investments. Suppose you have
an opportunity to purchase an annuity investment that promises to pay $700 per year
for 5 years. You know that youll receive a total of $3,500 ($700 5 years) over the
5-year period. However, you wish to earn a minimum annual return of 5% on your
investments. Whats the most you should pay for this annuity today? You can answer
this question by rearranging the terms in the formula to get:
Initial deposit  Annual withdrawal  Present value annuity factor

0
$3,030.30

End of Year

CALCULATOR
INPUTS
700
5
5

Adapting the equation to this situation, initial deposit represents the maximum
price to pay for the annuity, and annual withdrawal represents the annual annuity payment of $700. The present value annuity factor for 5 years and 5% (found in
Appendix D) is 4.329. Substituting this into the equation, we obtain:
Initial deposit  $700  4.329  $3,030.30

FUNCTIONS
PMT
N
I
CPT
PV
SOLUTION
3,030.63

The most you should pay for the $700, 5-year annuity, given your 5% annual return,
is about $3,030. At this price, youd earn 5% on the investment.
Using the present value concept, you can easily determine the present value of a
sum to be received in the future, equal annual future withdrawals available from an
initial deposit, and the initial deposit that would generate a given stream of equal
annual withdrawals. These procedures, like future value concepts, allow you to place
monetary values on long-term financial goals.

See Appendix E for details.

Concept Check
2-14

Why is it important to use time value of money concepts in setting personal


financial goals?

2-15

What is compounding? Explain the rule of 72.

2-16

When might you use future value? Present value? Give specific examples.

SUMMARY
LG1

Understand the interlocking network of financial plans


and statements.
Preparing and using personal financial statementsthe balance sheet and the income and
expense statementis important to personal
financial planning. These tools help you to keep
track of your current financial position and to monitor progress toward achieving financial goals.
Also important is a budget, which allows you to
monitor and control your spending in light of your
financial plans.

LG2

Prepare a personal balance sheet.


A balance sheet reports on your financial position at a specific time. It summarizes the
things you own (assets), the money you owe
(liabilities), and your financial worth (net worth).
Assets include liquid assets, investments, and
real and personal property. Liabilities include
current liabilities that are due in less than 1 year
(unpaid bills, open account credit obligations)
and long-term liabilities (real estate mortgages,
consumer installment loans, education loans).

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67

Net worth represents your actual wealth and is


the difference between your total assets and
total liabilities.
LG3

Generate a personal income and expense statement.


The income and expense statement summarizes
the income you received and the money you
spent over a specific period. Its prepared on a
cash basis and thus reflects your actual cash flow.
Expenses consist of cash outflows to (1) meet living expenses, (2) pay taxes, (3) purchase various
kinds of assets, and (4) pay debts. A cash surplus
(or deficit) is the difference between income
and expenses. A cash surplus can be used to
increase assets or reduce debts, and it therefore
has a positive effect on the balance sheets net
worth account. A cash deficit, in contrast, reduces
assets or increases debts, acting to reduce net
worth.

LG4

Develop a good record-keeping system and use ratios


to interpret personal financial statements.
Good records make it easier to prepare accurate personal financial statements. Organized
records also simplify tax return preparation
and provide the necessary documentation for
tax deductions. Ratio analysis allows you to
interpret your personal financial statements
to assess how well you are doing relative to

your past performance. Four important financial


ratios are the solvency, liquidity, savings, and
debt service ratios.
LG5

Construct a cash budget and use it to monitor and


control spending.
A cash budget helps you to carry out a system
of disciplined spending. By curbing needless
spending, a budget can increase the amount
of funds allocated to savings and investments.
Household budgets identify planned monthly
cash income and cash expenses for the coming year. The objective is to take in more
money than you spend, so youll save money
and add to your net worth over time. The final
step in the budgeting process is to compare
actual income and expenses with budgeted
figures to learn whether youre living within
your budget and, if not, to make appropriate
adjustments.

LG6

Describe the use of time value of money concepts to


put a monetary value on financial goals.
When putting a dollar value on financial goals, be
sure to consider the time value of money and,
if appropriate, use the notion of future value or
present value to prepare your estimates. These
techniques explicitly recognize that a dollar today
is worth more than a dollar in the future.

FINANCIAL PLANNING EXERCISES

68

LG2, 3

1.

Michael Vaughn is preparing his balance sheet and income and expense statement for the
year ending June 30, 2010. He is having difficulty classifying six items and asks for your
help. Which, if any, of the following transactions are assets, liabilities, income, or expense
items?
a. Michael rents a house for $950 a month.
b. On June 21, 2010, Michael bought diamond earrings for his wife and charged them using
his Visa card. The earrings cost $600, but he hasnt yet received the bill.
c. Michael borrowed $2,000 from his parents last fall, but so far he has made no payments to
them.
d. Michael makes monthly payments of $120 on an installment loan; about half of it is interest,
and the balance is repayment of principal. He has 20 payments left, totaling $2,400.
e. Michael paid $2,800 in taxes during the year and is due a tax refund of $450, which he
hasnt yet received.
f. Michael invested $1,800 in some common stock.

LG2, 3

2.

Put yourself 10 years into the future. Construct a fairly detailed and realistic balance sheet
and income and expense statement reflecting what you would like to achieve by that time.

LG2, 4

3.

Use Worksheet 2.1. Mary Skys banker has asked her to submit a personal balance sheet
as of June 30, 2010, in support of an application for a $3,000 home improvement loan. She

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comes to you for help in preparing it. So far, she has made the following list of her assets
and liabilities as of June 30, 2010:
Cash on hand
Balance in checking account
Balance in money market deposit
account with Southwest Savings
Bills outstanding:
Telephone
Electricity
Charge account balance
Visa
MasterCard
Taxes
Insurance
Condo and property
Condo mortgage loan
Automobile: 2006 Honda Civic
Installment loan balances:
Auto loans
Furniture loan
Personal property:
Furniture
Clothing
Investments:
U.S. government savings bonds
Stock of Safeco Corporation

70
180
650

$ 20
70
190
180
220
400
220

1,300
68,000
52,000
10,000

3,000
500

3,500

1,050
900

1,950

500
3,000

3,500

From the data given, prepare Mary Skys balance sheet, dated June 30, 2010 (follow the balance sheet form shown in Worksheet 2.1). Then evaluate her balance sheet relative to the
following factors: (a) solvency, (b) liquidity, and (c) equity in her dominant asset.
LG3

4.

Use Worksheet 2.2. Jim and Beth Butler are about to construct their income and expense
statement for the year ending December 31, 2010. They have put together the following
income and expense information for 2010:
Beths salary
Reimbursement for travel expenses
Interest on:
Savings account
Bonds of Beta Corporation
Groceries
Rent
Utilities
Gas and auto expenses
Jims tuition, books, and supplies
Books, magazines, and periodicals
Clothing and other miscellaneous expenses
Cost of photographic equipment purchased with charge card
Amount paid to date on photographic equipment
Beths travel expenses
Purchase of a used car (cost)
Outstanding loan balance on car
Purchase of bonds in Beta Corporation

$47,000
1,950
110
70
4,150
9,600
960
650
3,300
280
2,700
2,200
1,600
1,950
9,750
7,300
4,900

Using the information provided, prepare an income and expense statement for the Butlers
for the year ending December 31, 2010 (follow the form shown in Worksheet 2.2).

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69

LG5

5.

Harvey and Marlyn Elliott are preparing their 2011 cash budget. Help the Elliotts reconcile
the following differences, giving reasons to support your answers.
a. Their only source of income is Harveys salary, which amounts to $5,000 a month before
taxes. Marlyn wants to show the $5,000 as their monthly income, whereas Harvey argues
that his take-home pay of $3,917 is the correct value to show.
b. Marlyn wants to make a provision for fun money, an idea that Harvey cannot understand. He asks, Why do we need fun money when everything is provided for in the
budget?

LG5

6.

Here is a portion of Rodney Rains budget record for April 2011. Fill in the blanks in columns
5 and 6.

Item
(1)
Rent
Utilities
Food
Auto
Recreation and
entertainment

70

Amount
Budgeted
(2)

Amount
Spent
(3)

Beginning
Balance
(4)

Monthly
Surplus
(Deficit)
(5)

Cumulative
Surplus
(Deficit)
(6)

$550
150
510
75

$575
145
475
95

$50
15
45
25

$_____
_____
_____
_____

$_____
_____
_____
_____

100

110

50

_____

_____

LG5

7.

Use Worksheet 2.3. Prepare a record of your income and expenses for the last 30 days;
then prepare a personal cash budget for the next 3 months. (Use the format in Worksheet
2.3 but fill out only 3 months and the Total column.) Use the cash budget to control and
regulate your expenses during the next month. Discuss the impact of the budget on your
spending behavior as well as any differences between your expected and actual spending
patterns.

LG6

8.

Use future or present value techniques to solve the following problems.


a. Starting with $10,000, how much will you have in 10 years if you can earn 8% on your
money? If you can earn only 5%?
b. If you inherited $25,000 today and invested all of it in a security that paid a 7% rate of
return, how much would you have in 25 years?
c. If the average new home costs $210,000 today, how much will it cost in 10 years if the
price increases by 5% each year?
d. You think that in 15 years it will cost $212,000 to provide your child with a 4-year college education. Will you have enough if you take $70,000 today and invest it for the next
15 years at 5%? If you start from scratch, how much will you have to save each year to
have $212,000 in 15 years if you can earn a 5% rate of return on your investments?
e. If you can earn 5%, how much will you have to save each year if you want to retire in
35 years with $1 million?
f. You plan to have $750,000 in savings and investments when you retire at age 60. Assuming
that you earn an average of 8% on this portfolio, what is the maximum annual withdrawal
you can make over a 25-year period of retirement?

LG6

9.

Over the past several years, Joyce Chen has been able to save regularly. As a result, today
she has $54,188 in savings and investments. She wants to establish her own business in
5 years and feels she will need $100,000 to do so.
a. If she can earn 6% on her money, how much will her $54,188 in savings/investments be
worth in 5 years? Will Joyce have the $100,000 she needs? If not, how much more money
will she need?
b. Given your answer to part a, how much will Joyce have to save each year over the
next 5 years to accumulate the additional money? Assume she can earn interest at a
rate of 6%.
c. If Joyce can afford to save only $4,000 a year then, given your answer to part a, will she
have the $100,000 she needs to start her own business in 5 years?

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LG6

10.

Carl Wilfred wishes to have $400,000 in a retirement fund 20 years from now. He can create
the retirement fund by making a single lump-sum deposit today.
a. If he can earn 6% on his investments, how much must Carl deposit today to create the
retirement fund? If he can earn only 4% on his investments? Compare and discuss the
results of your calculations.
b. If upon retirement in 20 years Carl plans to invest the $400,000 in a fund that earns 5%,
what is the maximum annual withdrawal he can make over the following 15 years?
c. How much would Carl need to have on deposit at retirement to annually withdraw $35,000
over the 15 years if the retirement fund earns 8%?
d. To achieve his annual withdrawal goal of $35,000 calculated in part c, how much more than
the amount calculated in part a must Carl deposit today in an investment earning 5% annual
interest?

11.

Bill Long wants to set up a fund to pay for his daughters education. In order to pay her
expenses, he will need $23,000 in 4 years, $24,300 in 5 years, $26,000 in 6 years, and $28,000
in 7 years. If he can put money into a fund that pays 6% interest, what lump-sum payment
must he place in the fund today to meet his college funding goals?

12.

Amy Stewart has always been interested in stocks. She has decided to invest $2,000 once
every year into an equity mutual fund that is expected to produce a return of 6% a year for
the foreseeable future. Amy is really curious how much money she can reasonably expect
her investment to be worth in 20 years. What would you tell her?

APPLYING PERSONAL FINANCE


Whats Your Condition?
Financial statements reflect your financial condition. They help you measure where you are now. Then,
as time passes and you prepare your financial statements periodically, you can use them to track your
progress toward financial goals. Good financial statements are also a must when you apply for a loan.
This project will help you to evaluate your current financial condition.
Look back at the discussion in this chapter on balance sheets and income and expense statements, and prepare your own. If youre doing this for the first time, it may not be as easy as it sounds!
Use the following questions to help you along.
1. Have you included all your assets at fair market value (not historical cost) on your balance sheet?
2. Have you included all your debt balances as liabilities on your balance sheet? (Dont take
your monthly payment amounts multiplied by the number of payments you have leftthis
total includes future interest.)
3. Have you included all items of income on your income and expense statement?
(Remember, your paycheck is income and not an asset on your balance sheet.)
4. Have you included all debt payments as expenses on your income and expense statement?
(Your phone bill is an expense for this month if youve already paid it. If the bill is still sitting
on your desk staring you in the face, its a liability on your balance sheet.)
5. Are there occasional expenses that youve forgotten about, or hidden expenses such as
entertainment that you have overlooked? Look back through your checkbook, spending
diary, or any other financial records to find these occasional or infrequent expenses.
6. Remember that items go on either the balance sheet or the income and expense statement, but not on both. For example, the $350 car payment you made this month is an
expense on your income and expense statement. The remaining $15,000 balance on
your car loan is a liability on your balance sheet, while the fair market value of your car at
$17,500 is an asset.
After completing your statements, calculate your solvency, liquidity, savings, and debt service ratios.
Now, use your statements and ratios to assess your current financial condition. Do you like where you

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71

are? If not, how can you get where you want to be? Use your financial statements and ratios to help
you formulate plans for the future.

CRITICAL THINKING CASES


2.1 The Gordons Version of Financial Planning

LG1, 2, 3, 4

Burt and Emily Gordon are a married couple in their mid-20s. Burt has a good start as a bank manager
and Emily works as a sales representative. Since their marriage 4 years ago, Burt and Emily have been
living comfortably. Their income has exceeded their expenses, and they have accumulated an enviable
net worth. This includes the $10,000 that they have built up in savings and investments. Because their
income has always been more than enough for them to have the lifestyle they desire, the Gordons
have done no financial planning.
Emily has just learned that shes 2 months pregnant. Shes concerned about how theyll make
ends meet if she quits work after their child is born. Each time she and Burt discuss the matter, he
tells her not to worry because weve always managed to pay our bills on time. Emily cant understand his attitude, because her income will be completely eliminated. To convince Emily theres no
need for concern, Burt points out that their expenses last year, but for the common stock purchase,
were about equal to his take-home pay. With an anticipated promotion to a managerial position and an
expected 10% pay raise, his income next year should exceed this amount. Burt also points out that
they can reduce luxuries (trips, recreation, and entertainment) and can always draw down their savings
or sell some of their stock if they get in a bind. When Emily asks about the long-run implications for
their finances, Burt says there will be no problems because his boss has assured him that he has
a bright future with the bank. Burt also emphasizes that Emily can go back to work in a few years if
necessary.
Despite Burts arguments, Emily feels that they should carefully examine their financial condition
in order to do some serious planning. She has gathered the following financial information for the year
ending December 31, 2010.
Salaries
Burt
Emily
Item
Food
Clothing
Mortgage payments, including property taxes of $1,400
Travel and entertainment card balances
Gas, electric, water expenses
Household furnishings
Telephone
Auto loan balance
Common stock investments
Bank credit card balances
Federal income taxes
State income tax
Social security contributions
Credit card loan payments
Cash on hand
2007 Nissan Sentra
Medical expenses (unreimbursed)
Homeowners insurance premiums paid
Checking account balance
Auto insurance premiums paid
Transportation

72

Take-home Pay

Gross Salary

$44,200
25,048

$64,000
36,000
Amount
$ 5,902
2,300
11,028
2,000
1,990
4,500
640
4,650
7,500
675
19,044
4,058
7,650
2,210
85
15,000
600
1,300
485
1,600
2,800

Part 1 | Foundations of Financial Planning

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Cable television
Estimated value of home
Trip to Europe
Recreation and entertainment
Auto loan payments
Money market account balance
Purchase of common stock
Addition to money market account
Mortgage on home

680
185,000
5,000
4,000
2,150
2,500
7,500
500
148,000

Critical Thinking Questions


1.
2.

3.

Using this information and Worksheets 2.1 and 2.2, construct the Gordons balance sheet and
income and expense statement for the year ending December 31, 2010.
Comment on the Gordons financial condition regarding (a) solvency, (b) liquidity, (c) savings, and
(d) ability to pay debts promptly. If the Gordons continue to manage their finances as described,
what do you expect the long-run consequences to be? Discuss.
Critically evaluate the Gordons approach to financial planning. Point out any fallacies in Burts arguments, and be sure to mention (a) implications for the long term as well as (b) the potential impact
of inflation in general and specifically on their net worth. What procedures should they use to get
their financial house in order? Be sure to discuss the role that long- and short-term financial plans
and budgets might play.

2.2 Jim Pavlov Learns to Budget


Jim Pavlov graduated from college in 2009 and moved to Atlanta to take a job as a market research
analyst. He was pleased to be financially independent and was sure that, with his $45,000 salary, he
could cover his living expenses and have plenty of money left over to furnish his studio apartment
and enjoy the wide variety of social and recreational activities available in Atlanta. He opened several
department-store charge accounts and obtained a bank credit card.
For a while, Jim managed pretty well on his monthly take-home pay of $2,893; but by the end of
2010, he was having trouble fully paying all his credit card charges each month. Concerned that his
spending had gotten out of control and that he was barely making it from paycheck to paycheck, he
decided to list his expenses for the past calendar year and develop a budget. He hoped not only to
reduce his credit card debt but also to begin a regular savings program.
Jim prepared the following summary of expenses for 2010.
Item

Annual Expenditure

Rent
$12,000
Auto insurance
1,855
Auto loan payments
3,840
Auto expenses (gas, repairs, and fees)
1,560
Clothing
3,200
Installment loan for stereo
540
Personal care
424
Phone
600
Cable TV
440
Gas and electricity
1,080
Medical care
120
Dentist
70
Groceries
2,500
Dining out
2,600
Furniture purchases
1,200
Recreation and entertainment
2,900
Other expenses
600
After reviewing his 2010 expenses, Jim made the following assumptions about his expenses for
2011:
1. All expenses will remain at the same levels, with these exceptions:
a. Auto insurance, auto expenses, gas and electricity, and groceries will increase 5%.
b. Clothing purchases will decrease to $2,250.

Chapter 2 | Developing Your Financial Statements and Plans

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73

2.

3.
4.

c. Phone and cable TV will increase $5 per month.


d. Furniture purchases will decrease to $660, most of which is for a new television.
e. He will take a 1-week vacation to Colorado in July at a cost of $2,100.
All expenses will be budgeted in equal monthly installments except for the vacation and these
items:
a. Auto insurance is paid in two installments due in June and December.
b. He plans to replace the brakes on his car in February at a cost of $220.
c. Visits to the dentist will be made in March and September.
He will eliminate his bank credit card balance by making extra monthly payments of $75 during
each of the first 6 months.
Regarding his income, Jim has just received a small raise, so his take-home pay will be $3,200 per
month.

Critical Thinking Questions


1.

2.
3.

a.

Prepare a preliminary cash budget for Jim for the year ending December 31, 2011, using the
format shown in Worksheet 2.3.
b. Compare Jims estimated expenses with his expected income, and make recommendations
that will help him balance his budget.
Make any necessary adjustments to Jims estimated monthly expenses, and revise his annual
cash budget for the year ending December 31, 2011, using Worksheet 2.3.
Analyze the budget and advise Jim on his financial situation. Suggest some long-term, intermediate, and short-term financial goals for Jim, and discuss some steps he can take to reach them.

MONEY ONLINE!
Visit www.cengage.com/finance/gitman for some additional Web-based exercises and hot links
(with annotations) to a variety of resources relevant to the topics covered in this chapter.

74

Part 1 | Foundations of Financial Planning

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.