Chapter 2
Measuring Your Financial
Health and Making a Plan
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Using A Balance Sheet to
Measure Your Wealth
 Personal
balance sheet: the financial
Polaroid
 The financial equation: calculating net
worth or equity
Assets - Liabilities = Net Worth
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Your Assets: What You Own
 Monetary
 Investment
 Retirement
plans
 Real
estate
 Automobiles and other vehicles
 Personal property
 Other tangible and intangible assets
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Monetary Assets:



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Cash or other assets
that can be easily
converted into cash
These assets provide
necessary liquidity in
case of an emergency.
Examples -- cash,
checking accounts,
savings accounts
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Investment Assets:



Assets that are invested
for the future
These assets are used
to accumulate wealth to
satisfy a goal.
Examples -- stocks,
bonds, mutual funds,
cash value life
insurance
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Retirement Plans:



Investments by you or
your employer to save
for retirement
Long-term investments
that often carry a
penalty if used before a
certain age
Examples -- pensions,
IRAs, 401(k), 403(b),
Keogh, or SEP-IRA
plans
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Real Estate:



Tangible asset such as
land and a dwelling,
reported as fair market
value
Represents most of
your savings, and
normally appreciates in
value
Examples -- primary
residence, vacation
home, and rental
property
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Automobiles and Other
Vehicles:



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Tangible assets that
normally must be
inspected and licensed
Reported as fair market
value, but normally
depreciate in value
Examples -- cars,
trucks, motorcycles,
and recreational
vehicles
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Personal Property:
 Tangible
assets that
represent your lifestyle
 Reported as fair market
value, but normally
depreciate in value
 Examples -- boats,
furniture, electronics,
clothing, jewelry
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Other Assets:
 Any
other tangible or intangible asset
that may or may not be of value
 Examples -- business ownership,
collections, money owed you
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Your Liabilities: What You
Owe
 Current
liabilities are liabilities that must
be paid-off within the next year.
– examples -- credit cards and utility bills
 Long-term
liabilities are liabilities that
extend beyond one year.
– examples -- home mortgage and auto
loans
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Your Net Worth: A Measure of
Your Wealth
 Insolvency:
do you owe more than you
own?
 How age affects net worth guidelines
 Uses of a balance sheet
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Using an Income Statement to
Trace Your Money
 Personal
income statement -- the
financial motion picture
 Cash basis: statement based entirely
on actual cash flows
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Income: Where Your Money
Comes From
Sources of income:
wages, tips,
royalties, salary, and
commissions
 Income is amount
earned, not
necessarily amount
received.

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Expenditures: Where Your
Money Goes
 The
two major expenditure categories:
taxes and living expenses
 Fixed expenses: Expenses you don’t
directly control -- e.g., mortgage, rent,
cable TV
 Variable expense: Expenses you can
control -- e.g., food, entertainment,
clothing
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Where Does It Go, On
Average?
Taxes, Food,
Housing, Medical
Care
 The more earned,
the more spent on
education and
entertainment.

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Using Ratios: A Financial
Thermometer
 Question
1: Do you have adequate
liquidity to meet emergencies?
 Question 2: Do you have the ability to
meet your debt obligations?
 Question 3: Are you saving as much as
you think you are?
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Question 1: Do You Have
Adequate Liquidity
 Ratios
to determine whether or not you
have enough monetary assets (1) to
pay for an unexpected large expense or
(2) to tide you over during periods of
reduced or eliminated earnings.
– Current ratio
– Month’s living expenses covered ratio
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Current Ratio
monetary assets
current liabilities

 This
ratio shows you whether you have
enough liquid assets to cover expenses
currently due.
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Interpretation
 Ratio
greater than 2
recommended
 Track the trend and
if going down -make changes
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Month’s Living Expenses
Covered Ratio
monetary assets
month’s living expenses

 This
ratio tells you how many months
living expenses you can cover with your
present level of monetary assets.
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Interpretation


The rule of thumb: 3 to
6 months of expenses
Factors that affect the
rule of thumb:
– Available credit cards or
home equity loans
– Potential for higher
earnings on less liquid
accounts
– Stability of income

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Track the trend and if
going down--make
changes
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Question 2: Can You Meet
Your Debt Obligations?
 Ratios
to determine whether or not you
can meet current or long-term debt
obligations:
– Debt ratio
– Long-term debt coverage ratio
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Debt Ratio
total liabilities
total assets

 This
ratio tells you whether you could
payoff all your liabilities if you liquidated
all your assets.
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Interpretation
Represents
percentage of
assets financed with
borrowing
 Track the trend;
ratio should go
down with age

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Long-term Debt Coverage
Ratio
total income available for living expenses
total long-term debt payment

 This
ratio tells you how many times you
could make your debt payments with
your current income.
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Interpretation
 Ratio
of 2.5 or greater
recommended
 Track the trend and if
going down -- make
changes
 Consider the inverse -the percentage of takehome pay needed to
repay debt
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Question 3: Are You Saving As
Much As You Think?
 Ratio
to determine whether you are
saving as much of your income as you
think.
– Savings ratio
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Savings Ratio
income available for savings
income available for living expenses

 This
ratio tells you what proportion of
your after-tax income is being saved.
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Interpretation
U.S. rate typically
3% - 8%
 Varies with stage of
the financial life
cycle and goals

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Record Keeping
 The
three reasons for accurate record
keeping
– Preparing taxes
– Tracking expenses
– Providing information for others to use in
the event of an emergency
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Record Keeping (cont’d)
 The
two steps of record keeping
– Tracking your personal financial dealings
– Storing your financial records in an
accessible manner
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Ways to Track Expenditures
Using checks and credit cards: Those
expenditures leave a paper trail
 Using cash: Record expenditures in a
notebook or ledger
 Generating a monthly income and expense
statement
 Using computer programs to track all
financial transactions
 Learning what and where to keep records

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Taxes
 Keep
all tax-related receipts and
records for 6 years.
 Always keep accurate tax records in the
event of an audit.
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Putting It All Together: A
Review
Evaluate your financial health: balance sheet,
income statement, and ratios
 Define your financial goals: must know how
much you can save
 Develop a plan of action: use the income
statement and a cash budget
 Implement your plan: Just do it!
 Review your progress, reevaluate, and revise
your plan: back to the balance sheet, income
statement, ratios, and budget

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A Cash Budget
A plan for controlling
cash inflows and
outflows
 Purpose: To
balance income with
expenditures AND
savings

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Putting It All Together:
Budgeting
Evaluate your
financial health and
your financial plan
 Develop a cash
budget
 Implement a cash
budget

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Developing a Cash Budget
Examine last year’s total income and adjust
for the current year.
 Estimate your tax liability.
 Identify all fixed expenditures.
 Identify all variable expenditures.
 Look for ways to reduce your variable
expenses.
 Consider the effect of credit payments on
future income

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Calculating the Bottom Line
Take Home Pay
Living Expenses
Money for
Savings
GOALS
Spend Less
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Earn More
Downsize
Goals
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Implementing a Cash Budget
 Try
the budget for a month.
 Adjust the plan or your expenses as
necessary to maintain the plan.
 Try the envelope system.
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Managing Your Own Affairs
Versus Hiring a Professional
 The
3 options
– Go it alone,make a plan and have it
checked by a professional.
– Work with a professional and develop a
plan.
– Let the professional do it all.
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Paying Your Financial
Planner:
 Fee-only
planners derive income from
charging the client for the service
provided or for a financial plan.
 Commission-based planners derive
income from the sale of financial
products.
 Some planners charge a combination of
fees and commissions.
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Choosing a Professional
Planner
 Pick
a competent planner with
accreditation(s) from a professional
organization(s).
 Pick a planner with whom you are
comfortable.
 Pick a planner with experience.
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Choosing a Professional
Planner (cont’d)
Before hiring a
planner, ask lots of
questions about
his/her history.
 Call professional
organizations to get
recommendations.

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Summary
 Balance
sheet -- determines net worth
based on a comparison of assets and
liabilities
 Income statement -- summarizes cash
inflows and cash outflows
 Financial ratios -- diagnose your
financial health
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Summary (cont’d)
Record keeping -- implement strategies to
accurately track expenses and maintain
necessary financial records for the future
 Cash budget -- provides a plan for achieving
your goals by balancing cash inflows and
outflows
 Financial planners -- can provide many levels
of assistance for your planning needs

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