CHAPTER 2: DEVELOPING YOUR FINANCIAL STATEMENTS AND PLANS

LG1: Mapping Out Your Financial Future

Financial plans, financial statements, and budgets provide direction by helping you work toward
specific financial goals. Financial plans are the roadmaps that show you the way, whereas
personal financial statements let you know where you stand financially. 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 provide control by bringing the various dimensions of your personal
financial affairs into focus.

The Role of Financial Statements in Financial Planning

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. 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.

The balance sheet describes your financial position – the assets you hold, less the debts you
owe, equal your net worth (general level of wealth) – at a given point in time. In contrast, the
income and expense statement measure financial performance over time. Budgets are forward
looking and allow you to monitor and control spending because they are based on expected
income and expenses. Financial plans provide direction to annual budgets.

LG2: The Balance Sheet: How Much Are You Worth Today?
A balance sheet is like a snapshot taken of your financial position on one day out of the year. It
has three parts that summarize your financial picture:
 Assets: what you own
 Liabilities: 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.

Assets: the things you own

Assets are the items you own. An item is classified as an asset regardless of whether it was
purchased for cash or financed with debt. A useful way to group assets is based on their
underlying characteristics and uses. This results in four broad categories:
 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.
 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.
 Real property: tangible assets that we use in our everyday lives. This refers to
immovable property such as land and anything fixed to it (i.e., house). Real property 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 similar items.

All assets are recorded on the balance sheets as their current fair market value. Fair market
value is either the actual value of the asset or the price for which the asset can be reasonably be
expected to sell in the open market. Under generally accepted accounting principles (GAAP), the
accounting profession’s guiding rules, assets appear on a company’s balance sheet at cost, not
fair market value.

Liabilities: the money you owe

Liabilities represent an individual’s or family’s debts. They are generally classified according to
maturity.
 Current, or short-term, liabilities: any debt currently owed and due within 1 year of the
date of the balance sheet.
 Long-term liabilities: debt due 1 year or more from the date of the balance sheet.

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 due – not the initial
loan balance – that matters. Another important point is that only the principal portion of a loan
or mortgage should be listed as a liability on the balance sheet.

Net worth: a measure of your financial worth

Net worth is the amount of accrual wealth or equity that an individual or family has in its owned
assets. It represents the amount of money you’d have left after selling all your owned assets at
their estimated fair market values and paying off all your liabilities. If net worth is less than zero,
the family is technically insolvent. Although this form of insolvency – which is the financial
state in which net worth is less than zero – doesn’t 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.

Balance sheet format and preparation

You should prepare your personal balance sheet at least once a year, preferably every 3 to 6
months.
1. List your assets at their fair market value as of the date you are preparing the balance
sheet.
2. List all current and long-term liabilities.
3. Calculate net worth.

LG3: The Income and Expense Statement: What We Earn and Where It Goes
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. The
income and expense statement has three major parts: income (sources next paragraph), expenses
(definition next paragraphs), 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 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.

Income: cash in
Common sources of income include earnings received as wages, salaries, self-employment
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.

Expenses: cash out

Expenses represent money used for outlays. Some are fixed expenses – usually contractual,
predetermined, and involving equal payments each period (typically each month such as
mortgage, insurance premiums, 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.

Cash surplus (or deficit)

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 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.

Preparing the income and expense statement

The income and expense statement is dated to define the period covered. To prepare the
statement:
1. Record your income from all sources for the chosen period.
2. Establish meaningful expense categories.
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.

LG4: Using Your Personal Financial Statements

Keeping Good Records

A good recordkeeping system helps you manage and control your personal financial affairs. 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.

Tracking Financial Progress: Ratio Analysis

Calculating certain financial ratios can help you evaluate your financial performance over time.
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 relate primarily to the income and expense statement.
 1. Solvency ratio: (total net worth / total assets) shows, as a percentage, your degree of
exposure to insolvency, or how much “cushion” you have as a protection against
insolvency.
2. Liquidity ratio: (total liquid assets / total current debts) deals directly with the ability to
pay current debts. It shows how long you could continue to pay current debts (any bills or
charges that must be paid within 1 year) with existing liquid assets in the event of income
loss. The amount of liquid reserves will vary with your personal circumstances and
“comfort level.” Another useful liquidity guideline is to have a reserve fund equal to 3 to
6 months of after tax-income available to cover living expenses.
3. Savings ratio: (cash surplus / income after taxes) indicates relative amount of cash
surplus achieved during a given period.
4. Debt service ratio: (total monthly loan payments / monthly gross before tax income)
provides a measure of the ability to pay debts promptly. This ratio allows you to make
sure you can comfortably meet your debt obligations.

LG5: Cash In and Cash Out: Preparing and Using Budgets

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. 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 spending – as 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.

The Budgeting Process

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 expense.
The cash budget preparation process has three stages:
1. Estimating income: include all income expected for the year. Unlike the income and
expense statement, in the cash budget you should use take-home pay (rather than gross
income). In effect, take-home pay represents the amount of disposable income you
receive from your employer.
2. 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
commonly done using actual expenses from previous years, along with predetermined
short-term financial goals. Whether or not you have historical information, when
preparing your budget be aware of your expenditure patterns and how you spend money.
Don’t forget an allowance for “fun money,” which family members can spend as they
wish.
 3. Finalizing the cash budget: 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, you’ll 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.

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

Three options to choose from if your budget shows an annual budget deficit even after you’ve
made a few expense adjustments.
 Liquidate enough savings and investments or borrow enough to meet the total budget
shortfall for the year.
 Cut low-priority expenses from the budget.
 Increase income.

Using Your Budgets

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 you
budget limits. You can 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.

LG6: The Time Value of Money: Putting a Dollar Value on Financial Goals

The concept called time value of money is 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.

Future value is the value to which an amount today will grow if it earns a specific rate of
interest over a given period. Compounding interest is the interest earned each year that is left in
the account and becomes part of the balance/principal on which interest is earned in subsequent
years.
1. Future value of a single amount
Future value = amount invested x future value factor
For example, 45,000 is needed for a down payment to buy a house in 6 years. You have
already accumulated 5,000. To find the future value of that investment in 6 years earning
5%, the solution is: (for the future value factor, refer to table)
Future value = 5,000 x 1.340 = 6,700
In 6 years, then, you will have 6,700 if you invest the 5,000 at 5%. Since you need
45,000, you are still 38,300 short of your goal.
2. Future value of an annuity
Yearly savings = amount of money desired / future value annuity factor
 An annuity is a fixed sum of money that occurs annually. To find out how much to save
each year to accumulate 38,300 in 6 years with a 5% rate of return, the solution is:
Yearly savings = 38,300 / 6.802 = 5,630.70
You’ll need to save about 5,630.70 a year to reach your goal. You must add 5,630.70 each
year to the 5,000 you initially invested to accumulate 45,000. If you didn’t have 5,000 to
start with:
Yearly savings = 45,000 / 6.802 = 6,615.70

Present value is the value today of an amount to be received in the future. It represents the
amount you’d have to invest today at a given interest rate over the specific time to accumulate
the future amount. The process of finding present value is called discounting, which is the
inverse of compounding to find future value.
1. Present value of a single amount
Present value = future value x present value factor
You have just won 100,000 in your state lottery. Because you’re 30 years old, you want to
use part of it for your retirement fund. Your goal is to accumulate 300,000 in the fund by
the time you’re 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?
Present value = 300,000 x 0.295 = 88,500
88,500 is the amount you’d have to deposit today into an account paying 5% annual
interest in order to accumulate 300,000 at the end of 25 years.
2. Present value of an annuity
Annual withdrawal = initial deposit / present value annuity factor
At the age of 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). However, the funds still on deposit would continue to
earn 5% annual interest. To find the amount of the equal annual withdrawal:
Annual withdrawal = 300,000 / 15.373 = 19,514.73
Therefore, you can withdraw 19,514.73 each year for 30 years.
3. Other applications of present value
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 you’ll receive a total of 3,500 (700 x 5 years) over the 5-year
period. However, you wish to earn a minimum annual return of 5% on your investments.
What’s the most you should pay for this annuity today?
Initial deposit = annual withdrawal x present value annuity factor
Initial deposit = 700 x 4.329 = 3,030.30
The most you should pay for the 700, 5-year annuity, given your 5% annual return, is
about 3,030.30. At this price, you’d 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.