Chapter 2:
Financial Planning
Objectives
• Explain the concept of financial planning,
its components, and its benefits.
• Describe financial statements, particularly
the balance sheet and the income and
expense statement.
• Use financial ratios to evaluate your
financial strength and progress.
Objectives
• Identify the purposes and methods of
financial recordkeeping.
• Describe the use of computer software in
personal financial planning.
• Explain how to choose a professional
financial planner.
Financial Planning
The process of developing and
implementing a coordinated series of
financial plans to achieve financial
success.
Common Financial Behaviors
BEWARE!
• No clear goals
• Disorganized records
• Lack of economic understanding
• Flawed decision making
Components of Successful Financial Planning
• Specified values
• Explicitly stated goals
• Informed economic projections
• Logical and consistent financial
strategies
Economic Data
Living
Expenses
Earnings
Earnings
Values
Attitudes
Lifestyle
Wants
Needs
Relationships
Money
Wealth
Earnings
Managerial Effort
Planning
Decision Making
Implementing
Controlling
Evaluating
Coping and Adapting
Feedback
Communication
Financial Plans
For Spending/Saving
Financial Plans
For Risk Management
Input
Throughput
Achievement
Of Financial
Objectives
Financial Plans
For Capital Accumulation
Output
Financial Statements
FUNCTIONS PERFORMED:
• Compilation of financial data
• Communicate information
• Indicate financial condition
• Prepares user to read corporate financial
statements
The Balance Sheet
VALUE OF EVERYTHING OWNED MINUS
EVERYTHING OWED:
• Assets – Items owned
• Liabilities- Items owed
• Net worth– Difference between what
one owns and owes.
Assets- Liabilities = Net Worth
Assets
• Monetary assets
• Tangible or use assets
• Investment assets
Liabilities
• Short-term liabilities – anything that will be
paid off in 12 months or less.
• Long-term liabilities—anything that will still
have a balance after 12 months.
Income - Expense Statement
SUMMARY OF CASH-FLOW
TRANSACTIONS OVER TIME:
•Income – How much you made.
•Expenses – How much you spent.
•Net gain or loss—How much you have
left.
•Income – Expenses = Net gain or loss
Incomes
• Salaries or wages
• Bonuses and commissions
• Child support and alimony
• Public assistance
• Social Security and pensions
Incomes
• Scholarships and grants
• Interest and dividends
• Income from the sale of assets
• Other income (gifts, tax refunds, rent,
royalties)
Expenses
• Fixed expenses—items that are the same
every month (you don’t have control over
these).
• e.g. house payment, car payment,
insurance premium
• Variable expenses—expense changes
based on the way you live (you have
control over these).
• e.g. meals, utilities, entertainment
Financial Ratios
OBJECTIVE ASSESSMENTS OF
FINANCIAL STATUS:
•
•
•
•
Basic liquidity ratio
Debt-to-asset ratio
Debt-service-to-income ratio
Investment-assets-to-net-worth ratio
Basic Liquidity Ratio
This ratio tell you how many months of expenses you could pay with the your
monetary assets. This would be significant if you lost your job and had to make
your monthly payments. In this example the person has 1.08 expense months
of monetary assets.
Debt-to-Asset Ratio
Debt Service-to-Income Ratio
Investment Assets-to-Net Worth Ratio
Good Debt vs. Bad Debt
Debt incurred for consumption is bad debt.
Bad Debt
= Debt Danger Ratio
Annual Income
Debt Danger Ratio beyond 25% can spell trouble.
Assessing Financial Progress
• Balance sheet
• Income - expense statement
• Financial ratios
• Am I spending, saving, and investing
money where I really want to?
Financial Recordkeeping
DETERMINE:
• Where you are
• Where you have been
• Where you are going
Recordkeeping Issues
• Original source records
• Safeguarding/storage of records
• Use of computer software
Professional Financial Planning
• Commission-only
• Fee-only
• Fee-based
• Designations and credentials
Key Words and Concepts
Financial Planning is the process of developing and implementing a coordinated series of
financial plans to achieve financial success.
Values are fundamental beliefs about what is important, desirable, and worthwhile.
Financial Goals are the specific long- and short-term objectives to be attained through
financial planning and management efforts.
Financial Strategies are preestablished plans of action to be implemented in specific
situations.
Financial Statements are compilations of personal financial data designed to communicate
information on money matters.
Balance Sheet (or net worth statement) describes an individual’s or family’s financial
condition on a specified date.
Income and Expense (or cash flow) Statement lists and summarizes income and expense
transactions that have taken place over a specific period of time.
Assets include everything you own that has monetary value.
Liabilities are your debt.
Net Worth is the dollar amount left when what is owed is subtracted from the dollar value of
what is owned. Everything should be calculated at fair market value.
Key Words and Concepts (Cont.)
Fair Market Value is the amount a buyer would pay a willing seller.
Monetary Assets (or liquid assets) include cash and near-cash items that can be readily
converted to cash.
Tangible (or use) Assets are physical assets that have fairly long lifespans and could be sold to
raise cash but whose primary purpose is to provide maintenance of one’s lifestyle.
Investment assets (also known as capital assets) include tangible and intangible items acquired
for the monetary benefits they provide.
Diversification of investments means the investor puts money in a variety of investments.
Short-term (or current) Liability is an obligation that will be paid off within one year.
Long-term Liability is an obligation that will be paid off in more than one year.
Insolvent means net worth is negative.
Fixed Expenses are usually paid in the same amount during each time period.
Variable Expenses are expenditures over which and individual has considerable control.
Net Gain/Loss shows the amount of money left after you subtract expenses from income.
Financial Ratios are objective numerical calculations designed to simplify making judgmental
assessments of financial strength over time.
Key Words and Concepts (Concl.)
Liquidity is the speed and ease with which an asset can be converted into cash.
Financial Ratios:
Basic Liquidity Ratio: monetary (liquid) assets
monetary expenses
Reveals the number of months a family could continue to meets its expenses from monetary
assets after a total loss of income. Families should have a basic liquidity ratio of 3.
Debt-to-Asset Ratio:
total debt
total assets
Measures the solvency and ability to pay debt
Debt Service-to-Income Ratio: annual debt repayments
gross income
Provides an incisive view of the total debt burden of an individual. A ratio of .36 or less
indicates that gross income is adequate to make debt repayments.
Investment Assets-to-Net Worth Ratio: investment assets
net worth
Expresses how well an individual is advancing toward their financial goals for capital
accumulation. Experts recommend 50% or higher.