Personal Financial Statements and Budget

1. Personal Financial Statements and Budget Chapter 3

2. Who Wants to Be a Millionaire? • Today’s millionaires typically • Are first generation affluent • Have simple lifestyles • Are aware of their financial standing • Are meticulous budgeters • Have a large emergency fund • Have an average net worth over fourteen times their average income • Save about twenty percent of their annual income • Wish to leave a large inheritance to their families • View of financial independence is more important than public displays of wealth

3. Who Wants to Be a Millionaire? • Financial statements and budgets can • Help you determine your current financial status and control your spending • Help you track progress toward your financial goals • Help you identify new goals to establish

4. Personal Financial Statements • Two primary statements exist • Income statement • Traces the flow of income and expenses • Balance sheet (statement of net worth) • Lists the current value of assets and liabilities • Your net worth is the difference between your assets and your liabilities

5. Personal Financial Statements • Financial statements will • Provide a current evaluation of your financial status • Allow evaluation of your current and future goals • Provide information for loan applications such as a mortgage • Offer a starting point for estate planning • Serve as the basis for future investments • Help detect current and potential financial problems • Provide necessary data for divorce and prenuptial agreements

6. Personal Financial Statements • Americans are not good at financial record keeping • Fewer than 50 percent of all people regularly balance their checkbook • Difficult to gather all information necessary to develop a complete set of financial statements

7. The Income Statement • Traces person’s or family’s annual income expenses and savings • Income • Includes are items such as wages, salary, interest and dividends • Taxes • Includes taxes such as property taxes, federal and state income taxes and social security and Medicare taxes

8. The Income Statement • Housing expenses • Includes items such as mortgage payments, furniture, utilities and other main expenses • Some housing expenses are tax deductible • Transportation • Includes items such as car payments, maintenance, gasoline, insurance and registration fees • Food • Includes items such as household, groceries, eating out

9. The Income Statement • Child care and medical expenses • Includes day care and medical insurance as well as medical bills not covered by insurance • Clothing and personal care • Includes a variety of the items such as shoes, haircuts, clothing, etc.

10. The Income Statement • Entertainment gifts and recreation • Includes items such as an annual vacation, inexpensive hobby, sports and weekend entertainment • Student loan payments • Life insurance premiums • Charitable contributions • Most are tax deductible so keep good records • Cash allowances • AKA spending money, represents incidental day-to-day expenses

11. The Income Statement • Available for saving and investment • Income less expenses = the amount left over for savings and investment • If expenses exceed income you’ll have to withdraw money from savings or investments or borrow • Investments could include saving for retirement or college fund

12. The Balance Sheet • Outlines the households assets (what it owns) and its liabilities (what it owes) • The difference represents net worth or equity • Represents a snapshot of assets and liabilities at a single point in time • Assets are generally listed in terms of how easily they can be converted to cash • Liabilities are generally listed in the order in which they are due

13. The Balance Sheet • Cash and near cash financial assets • Includes items such as a checking account, savings accounts, money market funds • Non-retirement financial assets • Includes items such as stocks, bonds, and mutual funds not held in retirement accounts • Retirement and other financial assets

14. The Balance Sheet • Real assets • Includes items such as a house, household furnishings, vehicles • Current liabilities • Debts due in a short period of time • Long term liabilities • Debts due over a longer period of time, such as a mortgage, student loans, car loan • Net worth • Value remaining after subtracting liabilities from assets

15. Interpreting Personal Financial Statements • Comparing this year to prior years • It may help to convert dollar figures into percentages • Financial ratios • Provide benchmarks of your current financial position • Can then be used to spot trouble areas • Helpful to compare over time

16. Relevant Financial Ratios • Liquidity ratio • Current financial assets ÷ monthly living expenses • Gives you an idea of how many months you could continue to meet your expenses should your income cease • Experts suggest a minimum liquidity ratio between three and six months • Debt to total assets ratio • Total liabilities ÷ total assets • Measures ability to pay your debt, or solvency • Measures what percentage of your assets were acquired using borrowed funds

17. Relevant Financial Ratios • Debt service ratio • Calculated by dividing periodic debt payments by a periodic after-tax income • Measures what percentage of your income is going to repay the loans and other debts • Lenders like to see a ratio of 40 percent or less • A ratio above this may make lenders reluctant to lend you additional money

18. Relevant Financial Ratios • Financial assets to net worth • Tells you what percentage of your net worth is made up of financial assets (vs. real assets) • The higher the ratio the better • Over time it indicates how well you’re doing toward your goal of wealth accumulation • The typical household’s ratio is around 30 percent

19. Preliminary Budgeting Concerns • Setting up an emergency fund • Helps cover unexpected expenses • Should be kept in readily available assets for easy access, such as a savings account or money market mutual fund • Experts suggest an emergency fund should equal three to six months of income

20. Preliminary Budgeting Concerns • Adequate insurance is crucial • Insurance protects your property and income should something unexpected happen • Insurance types include life, health, disability, and property and liability

21. Budgeting • The budget is normally prepared on a monthly basis • Many bills are paid only once a month • The budget is designed to monitor and control expenses • Permits you to track past and current expenses and plan future ones • A budget should never deprive you of what you need • It should support your short and long term goals

22. Budget Components • Income (cash inflows) • It includes all cash expected to flow into the household • Take home pay, bonuses, dividends, etc. • Expenses (cash outflows) • Fixed expenses • Includes mortgage payment (rent), insurance, payments to regular savings deposits • Variable expenses • Food, clothing, utility bills

23. Budget Format • Budget should be kept as simple as possible • Don’t overdo the number of categories • The basic information includes • Estimated income • Actual income • Estimated expenses and actual expenses • The difference between estimates and actual values

24. Consumer Spending Patterns • The average household in the U.S. spends about $36,000.00 a year • The largest single expense is housing • Consumer spending patterns vary with the age of the household • Younger households spend more on housing, entertainment, and transportation • Older households spend more on health care • Other factors affecting the budget include • Income, marital status, children, geographic location

25. Figure 3.6: Distribution of Consumer Spending

26. Record Keeping • Adequate financial records are necessary to prepare meaningful financial statements and budgets • Records need to be kept pertaining to your • Checking and savings accounts • Brokerage accounts • Mutual fund accounts • Retirement accounts • Wills and trusts • Real estate deeds • Safe deposit boxes • Life insurance policies • Credit cards • Tax records • Appraisals of certain assets such as art or antiques • Employee benefits • Financial statements

27. Record Keeping • Where should records be kept? • Home filing cabinet • Safe deposit box at a local bank • Protected from fire or theft • Fire resistant home safe • Personal computer • Store copies of the electronic files in different locations

28. Record Keeping • How long should records be kept? • Review records periodically to determine which are still essential and which are not • Some records can be discarded after a few months while others should be kept for several years • When destroying records you should shred them as they may contain very personal information