Budgets and Balance Sheets: Your Personal Financial Statements Essential Question: Why is a budget such a key component of the financial plan? Chapter 4

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-2 Learning Objectives Explain the steps involved in creating a budget Describe the steps involved in creating a personal balance sheet Understand the importance of budgeting in your financial plan

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-3 Creating a Budget Budget –A forecast of future cash inflows and outflows Creating a budget is a key part of your financial plan A budget provides guidance for reaching your personal goals It gives you a detailed roadmap to your financial future

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-4 Step 1: Create a Personal Cash Flow Statement Identify your current cash inflows and cash outflows Many cash inflows include salary, hourly wages, or allowance Cash outflows include car payment, rent, or phone bill See Figure 4.1 for an example of a Personal Cash Flow Statement

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-5 Figure 4.1: Terris’s Personal Cash Flow Statement

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-6 Step 2: Turn Your Cash Flow Statement into a Budget Forecast your net cash flows for a period a time into the future Think of how the cash flows might change from month to month Be sure to include expected, yet irregular expenses, such as school activity fees or vacation

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-7 Step 2: Turn Your Cash Flow Statement into a Budget A good budget should include unexpected expenses Adjust the budget as necessary as you get more information An annual budget helps identify times where you can save money and times when you will be spending more money See Figure 4.2 for an example of an annual budget

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-8 Figure 4.2: Terris’s Annual Budget

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-9 Working with and Improving Your Budget A budget will help you save money for: – major purchases –unexpected expenses –unexpected opportunities A budget will help you anticipate future cash shortfalls A budget is a great planning tool

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-10 Assessing the Accuracy of the Budget Forecast error –The difference between what you forecast to happen and what actually happened Evaluate your forecasts and compare those with the actual cash flows Keep an expense journal to track your spending After looking at your forecast error, you may need to adjust your spending Look at Figure 4.3 for an example forecast errors

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-11 Figure 4.3: Terris’s Actual Versus Forecast Cash Flows

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-12 What are the steps involved in creating a budget?

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-13 Step 1: Creating a personal cash flow statement Step 2: Turning a cash flow statement into a budget Step 3: Working with and improving your budget

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-14 Personal Balance Sheet Personal balance sheet –Statement that tells you what your financial position is at a point in time A personal balance sheet helps you make decisions on how to use extra money Knowing where you are financially will help guide in deciding how to manage: – your liquidity –your use of credit and borrowing –your investments –and more

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-15 Assets Assets on a balance sheet can be classified in several ways: –Liquid assets –Household assets –investments

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-16 Liquid Assets Liquid assets –Financial assets that are either cash or can be easily converted to cash without significant loss of value Liquid assets include money in checking and savings accounts They are necessary for covering unexpected emergency expenses It is important that they have quick availability It is also important for them to be making money

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-17 Math for Personal Finance Jeff has $1,000 in a savings account, $340 in his checking account, and $2,100 in stock that his grandmother gave him. He also owns his car, which is worth about $3,200 How much does Jeff have in liquid assets?

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-18 Math for Personal Finance Solution: Jeff’s liquid assets consist of the money in his savings and checking accounts, which is $1,000 + $340 = $1,340.

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-19 Household Assets Household assets –Include those assets owned by a household – cars, houses, furniture Market value –What something would be worth if you sold it today Another type of asset is household assets While creating your personal balance sheet, evaluate the true market value of these assets Kelley Blue Book (for cars), EBay, and other internet sites are good resources for determining the value of these assets

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-20 Investments Investment –Something you acquire with the ultimate goal of making money Investments are the third major category of assets Investments are something you buy that you believe will increase in value over time Some common investment assets are: –Stocks –Bonds –Real estate

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-21 Investments Bonds –Certificates that function like IOUs— promises to repay a certain amount of money at some future time When you buy a bond, you are essentially loaning the issuer money The issuer pays you interest until the maturity date People buy bonds expecting to receive interest income while they hold the bond and getting their money back when the bond matures Investing in bonds involves some risks

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-22 Investments Stocks –certificates that represent fractional ownership of a firm People buy stocks expecting that the company will do well and the value will increase Each share of ownership represents a percentage of the business and is called a share of stock Stocks can be risky It is possible that the value will decline or disappear altogether

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-23 Math for Personal Finance Emily owns 50 shares of Company Y’s stock that is currently selling for $170 a share. She also owns 65 shares of Company Z’s stock worth about $47 a share. What is the total value of her stock holdings?

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-24 Math for Personal Finance Solution: Company Y 50 x $170 = $8,500 Company Z 65 x $47 = $3,055 Total = $11,555

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-25 Investments Mutual funds –Professionally managed investments that allow investors to pool their money in order to invest in a larger variety of financial assets such as stocks and bonds from many different companies Mutual funds are managed by professionals who decide which stocks/bonds to purchase Individual investors who buy shares in the fund do not have to be experts in stock or bond selection The risk of loss is usually spread across many different investments

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-26 Investments Real estate –Homes, rental property, farms, and other land Real estate is another type of investment People invest in this hoping it will generate revenue over time and increase in value

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-27 Liabilities –Represent the amount of debt a person owes These debts can be put into 2 categories: –Current liabilities –Long-term liabilities

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-28 Liabilities Current liabilities –Debts that must be paid off within 1 year Credit card balances are the most common form of current liabilities for people A credit card acts like a short term loan that “should” be paid off every month When you pay the credit card bill, you are eliminating the current liability

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-29 Liabilities Long-term liabilities –Debt that will take longer than 1 year to pay off Examples of long-term liabilities include student loans, car loans, and home mortgages Each payment includes an interest component and some amount that will reduce the initial liability (principal) Note that many people use credit cards this way This leads to paying more money than originally intended

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-30 Net Worth Net worth –The difference between your assets and your liabilities Figuring your net worth is an easy way to measure your wealth You can figure your net worth with a personal balance sheet Refer to Figure 4.4 for an example of figuring out your net worth

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-31 Figure 4.4: Terris’s Personal Balance Sheet

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-32 Math for Personal Finance Lakisha’s car is worth about $6,000 and she still owes $1,200 on it. She has an outstanding credit card balance of $450. What is her net worth?

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-33 Math for Personal Finance Solution: Lakisha’s net worth is $6,000 - $1,200 - $450 = $4,350

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-34 Changes in the Personal Balance Sheet Your Personal Balance Sheet changes as you acquire new assets or liabilities This will affect your net worth There are 2 ways to increase your net worth 1.The value of your assets needs to increase by more than your liabilities 2.To pay down debt on your liabilities

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-35 Analysis of Your Personal Balance Sheet Lenders look at your personal balance sheet to determine if you can pay the loan Loan officers use a debt-to-asset ratio to determine if you have borrowed too much money Keep your personal balance sheet in good shape It can influence the options you have for making financial decisions and having a good financial plan

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-36 What are the steps in creating a personal balance sheet?

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-37 You need to identify and then add up all of your assets and all of your liabilities. You then subtract the total of your liabilities from the total of your assets to determine your net worth.

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-38 Budgeting and Your Financial Plan Your cash flows feed into your balance sheet If cash inflows exceeds cash outflows, you will either increase assets or reduce liability Take a look at Figure 4.5 to see how this will show up on your balance sheet in the form of increased net worth

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-39 Figure 4.5: Your Cash Flows and Balance Sheet

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-40 Budgeting and Your Financial Plan Budgeting helps in financial planning because it makes you answer the following questions: –How can I improve my net cash flows in the near term? –How can I improve my net cash flows in the long term? –What decisions should I make about using credit, borrowing, and investing?

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-41 EQ: Why is a budget such a key component of the financial plan?

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-42 Budgeting helps you evaluate your current financial condition and determine how to improve net cash flows and make wise credit, borrowing, and investment decisions.

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-43 Summary The budgeting process allows you to monitor and control cash inflows and outflows Examine the difference between your forecast and actual cash inflows and outflows You can anticipate future problems and make necessary adjustments

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-44 Summary Your personal balance sheet tells you your financial position at a point in time It is a summary of your assets, your liabilities, and your net worth Assets can be listed as liquid assets, household assets, and investments Liabilities represent the amount of debt you owe Liabilities can be split into two categories: –Current liabilities –Long-term liabilities

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-45 Summary Budgeting can help you manage your cash flows to increase your net worth You can use this in building a financial plan

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-46 Key Terms and Concepts Bond Budget Current liability Forecast error Household asset Investment Liability Liquid asset Long-term liability Market value Mutual fund Net worth Personal balance sheet Real estate Stock

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-47 Websites (Kelley Blue Book)