Chapter Two

Financial Planning

Learning Objectives
1. Explain elements of successful financial
planning.
2. Describe the balance sheet and the cash-flow
statement.
3. Use financial ratios to evaluate your financial
strength and progress.
4. Know which financial records to maintain and
where to keep them.
5. Understand which factors to consider when
choosing a professional financial planner.

Setting the Stage for Successful

Personal Financial Planning
Financial Planning:
developing and implementing financial
plans in order to achieve financial success.
is unique to each individual or family.
Question: What are some components of
financial planning?

Figure 2.1: Overview of Effective

Personal Financial Management

Values Provide the Base for Financial

Planning
Values: Fundamental beliefs about what
is important, desirable, and worthwhile.
Activity 1:
10 Things I Like to Do
Activity 2:
Needs versus Wants

Financial Goals Follow from Values

Financial Goals: objectives to be attained
through financial planning and management
Financial goals should be specific in terms
of both dollar amounts and the projected
dates by which they are to be achieved.
SMART goals: Specific, Measurable,
Achievable, Realistic, and Time-Related
Examples of SMART goals?

Developing Financial Statements

What are Financial Statements?
Compilations of personal financial data
used to analyze financial situation
Net worth statement (a.k.a., balance sheet)
Cash-flow (a.k.a., income and expense)
statement

Balance Sheet = Net Worth

Balance Sheet (Net Worth Statement):
Describes an individuals or familys
financial condition on a specified date.
A snapshot of your finances

Components of a Balance Sheet

Assets
Liabilities
Net Worth

Assets and Debts

What is Owned- Assets
Monetary Assets/Liquid Assets
Tangible (or Use) Assets
Investment Assets/Capital Assets

What Is OwedLiabilities
Short-term (or Current) Liabilities
Long-term Liabilities

Net WorthWhat Is Left

Net Worth Formula:
Net worth = assets - liabilities
or
Net worth = what is owned - what is owed
Questions: What is YOUR net worth?
Is it a positive number?
How do you increase net worth?

Table 2.2: Balance Sheet for a College

Student

The Cash-Flow Statement Tracks

Income and Expenses
Cash-Flow (Income and Expense)
Statement:
Lists and summarizes income and expense
transactions that have taken place over a
specific period of time (e.g., a month).
Many people dont have a clue about small
expenses that add up.
Suggestion: Track your income and
expenses for the coming week!

Income
Income is not limited to what is earned
from salaries and wages.
It also includes...
Gifts
Interest
Stock dividends
Scholarships
Other sources?

Expenses
Fixed Expenses:
Usually paid in the same amount during each
time period
They are often contractual

Variable Expenses:
Expenditures you can control.
Items/amounts differ from month to month.

Occasional Expenses
Pay infrequently (e.g., quarterly)

Surplus (Loss)
The surplus (loss)
shows the amount remaining after subtracting
expenditures from income.

Surplus/deficit formula:
Surplus(deficit) = total income - total
expenses
Surplus = Positive cash flow
Deficit = Negative cash flow

Table 2.4: Cash-Flow Statement for a College Student

Financial Ratios Assess Your Financial

Strength and Progress
Financial Ratios:
Calculations based on information
contained in financial statements.
Simplify judgments regarding financial
strength and condition.
Adequacy of emergency savings
Amount of household debt

Often used by lenders, financial advisors

Basic Liquidity Ratio

Liquidity: The speed and ease with
which an asset can be converted to cash.

Question:
What types of assets are liquid and what assets are not?

Basic Liquidity Ratio (Continued)

monetary (liquid) assets
Basic liquidity ratio
monthly expenses

Tells how long you could meet monthly

expenses with monetary assets after a loss
of income.
A higher number is betterWhy?
Three months is a good cushion
(emergency fund).
More may be needed if income varies
significantly from month to month.

Asset-to-Debt Ratio
total assets
Asset - to - debt Ratio
total debt

Compares total assets with total liabilities.

A higher number is betterWhy?
Is 1.0 or larger if net worth is positive
Should grow as you get older

Debt Service-to-Income Ratio

annual debt repayments
Debt service - to - income ratio
gross income

Provides a view of total debt burden

Should be a ratio of .36 or lower
A lower number is betterWhy?
Indicates ability to make payments for debts and housing payments
Rent or mortgage payments

Debt Payments-to-Disposable Income

Ratio
Disposable Personal Income: Takehome pay remaining after all deductions
are withheld (a.k.a., net income)

Question: What are some common payroll deductions?

Debt Payments-to-Disposable Income

Ratio (Continued)
Debt payments - to - disposable income ratio

monthly nonmortgage debt repayments

disposable income

Indicates ability to handle monthly debt payments other than a

mortgage.
20 percent or more is very high.
Over 15% can cause problems
(Even 10% for some families!)

A lower number is betterWhy?

Investment Assets-to-Total Assets

Ratio
monthly non - mortgage debt repayments
Investment assets - to - assets ratio
disposable income

Compares the value of investment assets to total assets.

A higher number is betterWhy?
Should increase as you get older.
Less than 20% in 20s
50% or more in later life

Savings Ratio
annual savings
Savings ratio
after - tax income
Compares dollars saved to after-tax income.
A higher number is betterWhy?

Financial Recordkeeping Saves Time

and Money
Some records will be original, legal
documents such as receipts, insurance
policies,canceled checks, retirement
account statements.
Other records will be ones you develop
in the course of financial planning such
as balance sheets and budgets.

Financial Recordkeeping Saves Time

and Money (Continued)
Some records can be stored safely at
home in a fire-resistant cabinet or safe.
Examples?

Others records should be safeguarded

more securely such as in a safe-deposit
box at bank.
Examples?

Keep a list of s.d. box items

Where to Seek Professional Financial

Planning Advice
A true financial planner should be able
to analyze a familys total needs in...
Investments
Taxes
Insurance
Education goals
Retirement planning
Estate planning

Develop a cohesive plan

How are Financial Planners

Compensated?
Commission-Only Financial Planners
Paid solely by commissions on products sold

Fee-Only Financial Planners

Charge a fee for services; no product sales

Fee-Based Financial Planners

Charge a fee and commissions on products

Fee-Offset Financial Planners

Fee reduced by commissions earned on products
sold to client

Golden Rules of Financial Planning

1. Develop a balance sheet; update annually
2. Develop cash-flow statements monthly or
quarterly and compile into annual statement
3. Calculate financial ratios periodically and
use them to assess financial progress
4. Develop a list of financial goals. Update and
revise your goals annually
5. Start an uncomplicated personal financial
record-keeping system to meet your needs