Planning Your Financial Future, 4e by: Boone, Kurtz & Hearth Personal Financial Statements and Budgets Chapter 3

2 American’s Spending/Saving Habits  Net worth of typical American household grew faster than income  A large percentage of households own common stock today  Share of family income devoted to debt repayment fell  Spending on health care, entertainment, and insurance rose at a faster rate than food, housing, or transportation  Typical household spent more than $13,000 on housing and slightly less than $5,500 on food

3 Financial Statements and Budgets  Can help you determine your current financial status and control your spending  Can help you track progress toward your financial goals  Can 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 household’s 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  Nonretirement 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 Figure 3.3: Median Household Net Worth in the United States

16 Figure 3.3: Median Household Net Worth in the United States

17 Interpreting Personal Financial Statements  Comparing the current 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

18 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

19 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

20 Relevant Financial Ratios  Financial-assets-to-net-worth ratio 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

21 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

22 Preliminary Budgeting Concerns  Insuring against financial disaster Insurance protects your property and income should something unexpected happen Insurance types include life, health, disability, and property and liability

23 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

24 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

25 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

26 Consumer Spending Patterns  The average household in the U.S. spends about $49,400 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

27 Figure 3.7: Distribution of Consumer Spending Source: Based on data from the Statistical Abstract of the United States.

28 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

29 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

30 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