Chapter 2

Financial Planning Skills

1
 "There are plenty of
ways to get ahead. The
first is so basic I'm
almost embarrassed to
say it: spend less than
you earn.“
Paul Clitheroe
 Introduction
• Financial planning requires specialist knowledge across
diverse areas.
• Technical skills are required in a number of business
disciplines particularly in the area of investments.
• It is important that investments are considered in terms
of the time value of money, the effect of inflation and
taxation, timing of cash flows and compounding
frequency.
 Learning objectives
After studying this chapter you should be able to:
1. prepare personal financial statements.
2. understand the purpose of analysing financial statements using ratio analysis.
3. describe the importance of financial mathematics skills for financial planners.
4. explain the concept of time value of money and the benefits of compound
interest.
5. understand the difference between nominal and effective interest rates.
6. understand the concept of net present value.
7. apply the time value of money concept to different investment choices.
8. explain the effect of taxation and inflation on the rate of return.
 Preparing personal
financial statements
Personal financial statements can be prepared in
two parts:
• Personal cash flow budget/statement includes:
– Anticipated income from all sources;
– Items of spending or expenditure.
• Personal balance sheet includes:
– Personal assets;
– Personal liabilities.
 Personal cash flow budget
• Income includes money received from salary, wages,
interest, profits, bonuses, fees charged, dividends,
distributions, social security pensions or allowances, and
any other earnings
• Expenditure includes payments for food, clothing, gas,
electricity, rent, interest on loans, rates, and any other
expenses
• Net Savings where Income > Expenditure
• Negative Savings (Deficit) where Expenditure > Income
 Personal balance sheet
• Demonstrates financial well being
• Assets are things of value we own such as bank
deposits, property, managed funds, etc.
• Liabilities are amounts of money we owe to other
people or organisations such as credit card debt, loans
and mortgage.
• Net worth is the difference between assets and liabilities
 Using financial ratios as a
planning tool
• The personal financial statements can be used to
calculate the following useful financial ratios to analyse
the family’s financial position:
– Equity or net worth ratio (net worth/total assets)
– Liquidity ratio (liquid assets/current debt)
– Savings ratio (savings/net income) and
– Debt service ratio ((annual debt/annual net income)/12)
 Financial mathematics skills
applied in financial planning
• Financial planners require strong working knowledge of
fundamental mathematical concepts that relate to
investment and retirement planning.
• These include a basic understanding of:
– The nature of compound interest;
– The time value of money.
 Compound interest and the
time value of money
• Most financial decisions involve benefits and costs
spread over time.
• People prefer cash now rather than later because:
– Risk or uncertainty of future collection;
– Opportunity cost;
– Postponement of present consumption.
• A dollar in the hand today is worth more than a dollar to
be received in the future.
Compound interest and the time
value of money (continued)
Future Value Example
• $1,000 invested at 8% for 4 years

Interest in year 1 = 8% x $1000 = $ 80.00

Interest in year 2 = 8% x ($1000+$80) = $
86.40
Interest in year 3 = 8% x ($1000+$ 80+$86.40) = $ 93.31
Interest in year 4 = 8% x ($1000+$ 80+$86.40+$93.31) = $100.78
Total $1 360.49
Compound interest and the time
value of money (continued)
Future Value Formula: FV = PV(1 + i)n
where
– FV = future value of an amount invested today
– PV = amount of present sum of money
– i = interest rate per period
–n = number of periods
Using the formula for the example, we get
FV = $1 000(1 + 0.08)4
= $1 360.49
Compound interest and the time
value of money (continued)
Present Value Example
How much do we need to invest now at 8% to
accumulate $1 360.49 in 4 years time?
Present Value Formula
PV = FV(1 + i)–n
PV = $1 360.49(1 + 0.08)–4
= $1 000
Compound interest and the time
value of money (continued)
Annuity Example (FV)
How much will we have at the end of 5 years if
we invest $500 at the end of each year at 7%?
Annuity Formula (FV)
FV = PMT[(1 + i)n – 1]
i
FV = $500[(1 + 0.07)5 – 1]
0.07
= $2 875.37
Compound interest and the time
value of money (continued)
Annuity Example (PV)
What is the present value of an annuity of $500 for 5 years
at 7%?
Annuity Formula (PV)
PV = PMT [1 – (1 + i)–n]
i
PV = $500[1 – (1 + 0.07)– 5]
0.07
= $2 050.10
 Nominal and effective
interest rates
• A nominal interest rate is the stated interest rate that a
bank might quote.

• However, the value of the investment is affected by the

frequency at which the interest rate is determined.

• The effective interest rate is the real rate after adjusting

for frequency of compounding.
 Nominal and effective interest
rates (continued)
• Since the time value of money formula assumes annual
compounding, to obtain the periodic interest rate (i) an
adjustment must be made:
– The number of years (n) is multiplied by the number
of compounding periods (m).
– The annual interest rate (j) is divided by the number
of compounding periods (m).
• Periodic interest rate formula is:
i = j/m
Nominal and effective interest
rates (continued)
 Nominal and effective interest
rates (continued)
Example
• We can illustrate the importance of understanding the difference
between nominal and effective interest rates by considering the
following interest rates quoted by three banks:

Bank A: 15%, compounded daily

Bank B: 15.5%, compounded quarterly

Bank C: 16%, compounded annually

 Nominal and effective interest
rates (continued)
Example
The effective interest rates for these three banks are as follows: