Copyright ©2004 Pearson Education, Inc. All rights reserved. Chapter 1 Overview of a Financial Plan

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-2 Chapter Objectives Introduce the subject of personal finance Identify the key components of a financial plan Outline the steps involved in developing your financial plan

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-3 Definitions Personal finance: the process of planning your spending, financing, and investing so as to optimize your financial situation Personal financial plan: a plan that specifies your financial goals and describes the spending, financing, and investing plans that are intended to achieve those goals

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-4 Definitions Opportunity cost: what you give up as a result of a decision

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-5 How You Benefit From An Understanding of Personal Finance Make your own financial decisions –Every spending decision has an opportunity cost Judge the advice of financial advisors –Make informed decisions Become a financial advisor –Many career opportunities available

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-6 Components of a Financial Plan Budgeting and tax planning Managing your liquidity Financing your large purchases Protecting your assets and income (insurance) Investing your money Planning your retirement and estate

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-7 A Plan for Your Budgeting and Tax Planning Budget planning: The process of forecasting future expenses and savings Evaluate your current financial position –Assets: what you own –Liabilities: what you owe –Net worth: the value of what you own minus the value of what you owe

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-8 Budgeting and Tax Planning Exhibit 1.1: How a Budget Affects Savings

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-9 A Plan to Manage Your Liquidity Liquidity: access to funds to cover any short-term cash deficiencies Money management: decisions regarding how much money to retain in a liquid form and how to allocate the funds among short-term investment instruments

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-10 A Plan to Manage Your Liquidity Credit management: decisions regarding how much credit to obtain to support your spending and which sources of credit to use

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-11 Managing Your Liquidity Exhibit 1.2: Managing Your Liquidity

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-12 A Plan for Your Financing Loans often needed for large expenditures –College tuition, car, house Managing loans –How much can you afford to borrow? –Determining maturity of the loan –Selecting a loan with a competitive interest rate

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-13 Financing Your Large Purchases Exhibit 1.3: Financing Process

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-14 A Plan for Your Investing Funds not needed for liquidity can be invested –Stocks, bonds, mutual funds, real estate All investments have some level of risk Risk: uncertainty surrounding the potential return on an investment

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-15 A Plan for Your Retirement and Estate This includes insurance planning, retirement planning, and estate planning –Retirement planning: determining how much money should be set aside each year for retirement and how those funds should be invested –Estate planning: determining how your wealth will be distributed before or upon your death

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-16 Exhibit 1.4: Components of Your Financial Plan Components of Your Financial Plan

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-17 How the Text Organization Relates to the Financial Plan’s Components Each of the six parts of the text covers one specific component of the financial plan An effective financial plan enhances net worth and builds wealth Follow the steps to a complete financial plan at the end of the school term

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-18 How the Text Organization Relates to the Financial Plan’s Components How the components relate to your cash flows –Cash inflows are cash that you receive –Cash outflows are cash that you spend –Budgeting balances income and spending –Liquidity deals with cash excesses or shortages

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-19 How the Text Organization Relates to the Financial Plan’s Components –Financing focuses on obtaining cash for large purchases or repaying loans –Protect assets and income by using cash for insurance and retirement –Investing uses cash to build wealth

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-20 How Financial Planning Relates to Cash Flow Exhibit 1.6: How Financial Planning Affects Your Cash Flows

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-21 Developing the Financial Plan Step 1. Establish Your Financial Goals –Types of goals Car, home, college, wealth, charity –Set realistic goals Stronger likelihood of reaching goals –Timing of goals Short term (within one year) Intermediate (between 1–5 years) Long term (beyond five years)

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-22 Developing the Financial Plan Step 2. Consider Your Current Financial Position –How your future financial position is tied to your education Consider your skills, interests, and career paths –How your future financial position is tied to your career choice Choose a career that will be enjoyable and suit your skills

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-23 Developing the Financial Plan

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-24 Developing the Financial Plan

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-25 Developing the Financial Plan Step 3. Identify and Evaluate Alternative Plans That Could Achieve Your Goals –Plans could be conservative or aggressive Step 4. Select and Implement the Best Plan for Achieving Your Goals –The Internet has valuable financial planning information

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-26 Developing the Financial Plan Focus on Ethics: Personal Financial Advice –Your objective is to get the best advice appropriate to your needs –Be wary of unethical behavior Difficult to discern –Be wary of incompetent advice Be alert, ask questions, carefully consider advice

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-27 Developing the Financial Plan Step 5. Evaluate Your Financial Plan –Keep plan in an accessible place and monitor your progress Step 6. Revise Your Financial Plan –Change plan as financial condition and financial goals change

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-28 How the Internet Facilitates Financial Planning The Internet provides information on all aspects of financial planning –Bank deposit rates –Prices of cars and homes –Financing rates –Prices of investments –Insurance premiums

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-29 How the Internet Facilitates Financial Planning Provides updated information on all parts of your financial plan –Current tax rates and regulations –Investment performances –Online calculators

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-30 How the Internet Facilitates Financial Planning 1.1 Financial Planning Online: Should You Pursue a Career in Financial Planning?

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-31 Financial Planning Online: Financial Planning Tools for You Go to This website provides much information and many tools that can be used for all aspects of financial planning. It also provides information for creating retirement plans and wills.

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-32 Integrating Key Concepts

Copyright ©2004 Pearson Education, Inc. All rights reserved.1-33 Looking Ahead Part 1: Financial Planning Tools –Chapter 1 showed an overview of a financial plan –Chapter 2 teaches personal financial statements –Chapter 3 teaches time value of money –Chapter 4 teaches tax planning Part 2: Liquidity Management Part 3: Financing Part 4: Protecting Your Wealth Part 5: Investing Part 6: Retirement and Estate Planning

Copyright ©2004 Pearson Education, Inc. All rights reserved. Chapter 2 Planning with Personal Financial Statements

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-35 Chapter Objectives Explain how to create your personal cash flow statement Identify the factors that affect your cash flows Show how to create a budget based on your forecasted cash flows Describe how to create your personal balance sheet

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-36 Chapter Objectives Explain how your net cash flows are related to your personal balance sheet (and therefore affect your wealth)

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-37 Personal Cash Flow Statement Personal cash flow statement: a financial statement that measures a person’s cash inflows and outflows Cash inflows include salaries, interest, dividends Cash outflows include all expenses, both large and small

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-38 Personal Cash Flow Statement Create a statement by recording your revenues and expenses over a period of time Net cash flows: cash inflows minus cash outflows

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-39 Personal Cash Flow Statement Exhibit 2.1: Personal Cash Flow Statement for Stephanie Spratt

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-40 Factors That Affect Cash Flow Factors affecting cash inflows: –Stage in your career path Closely related to your stage in the life cycle — college, career, retirement –Type of job Based on skill level and demand for those skills –Number of income earners in your household

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-41 Factors That Affect Cash Flow Factors affecting cash outflows: –Size of family –Age –Personal consumption behavior Some people spend all of their income and more while others spend mainly on necessities and concentrate on saving for the future

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-42 Creating a Budget Budget: a cash flow statement that is based on forecasted cash flows for a future time period Budgets are useful for anticipating either cash surpluses or cash deficiencies

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-43 Creating a Budget Exhibit 2.3: Stephanie Spratt’s Revised Personal Cash Flow Statement

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-44 Creating a Budget Anticipating cash shortages –Small shortages can usually be made up from your checking account –Budgets provide warning of shortages so that you can prepare for them Assessing the accuracy of the budget –Compare predicted cash flows to actual cash flows –Adjustment may be necessary

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-45 Creating a Budget Exhibit 2.5: Comparison of Stephanie Spratt’s Budgeted and Actual Cash Flow for This Month

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-46 Creating a Budget Forecast net cash flows over several months –Use the information for a typical month and adjust it for unusual expenses such as seasonal shopping –Allow for some unexpected expenses like medical care, car and home maintenance Create an annual budget by extending your budget out for longer periods

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-47 Creating a Budget

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-48 Creating a Budget Improve the budget –Periodically review the budget to see if you are progressing toward your goals –Look for areas that can be changed to improve the budget over time Focus on ethics –Don’t become overly dependent on others –Create a budget and stay within it

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-49 Financial Planning Online: Budgeting Tips Go to: Click on: Budget to Save This Web site provides tips on effective budgeting based on your goals.

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-50 Personal Balance Sheet Personal balance sheet: a summary of your assets (what you own), your liabilities (what you owe), and your net worth (assets minus liabilities) A balance sheet reflects your financial position at a specific point in time

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-51 Personal Balance Sheet Assets –Liquid assets are financial assets that can be easily sold without a loss in value –Household assets are items normally owned by a household, such as a home, a car, and furniture You need to establish market values for these assets — the amount you would receive if you sold the asset today

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-52 Personal Balance Sheet –Investments Bonds: certificates issued by borrower, usually firms and government agencies, to raise funds Stocks: certificates representing partial ownership in a firm

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-53 Personal Balance Sheet Mutual funds: investment companies that sell shares and invest the proceeds in investment instruments Real estate: holdings in rental property and land Rental property: housing or commercial property that is rented out to others

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-54 Personal Balance Sheet Liabilities –Current liabilities: debts that will be paid within a year –Long-term liabilities: debts that will be paid over a period longer than one year Net worth is the difference between the value of your assets and the value of your liabilities

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-55 Personal Balance Sheet Creating a personal balance sheet –Allows you to determine your net worth –Update it periodically to monitor changes in your net worth over time

Personal Balance Sheet Exhibit 2.7: Stephanie’s Spratt’s Personal Balance Sheet

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-57 Personal Balance Sheet Changes in the personal balance sheet –Some changes will affect both your personal balance sheet and your net worth –Other changes will affect you personal balance sheet and leave your net worth unchanged Consider the previous personal balance sheet with the purchase of a new car…

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-58 Financial Planning Online: The Impact of Reduced Spending Go to: sellingtools/calculators/budget sellingtools/calculators/budget Click on: “What’s it worth to reduce my spending?” This Web site provides an estimate of the savings you can accumulate by reducing spending.

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-59 Personal Balance Sheet Exhibit 2.8: Stephanie’s Personal Balance Sheet If She Purchases a New Car

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-60 Personal Balance Sheet Analysis of the personal balance sheet –Allows monitoring of liquidity, debt, and ability to save –Liquidity is measured by the liquidity ratio Liquidity ratio = Liquid assets/Current liabilities From personal balance sheet on previous slide 4,000/2,000 = 2 Higher result = greater liquidity

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-61 Personal Balance Sheet –Debt level is measured by debt-to-asset ratio Debt-to-Asset Ratio = Total liabilities/total assets From personal balance sheet on previous slide 2,000/9,000 = 22.22% Higher ratio = higher debt relative to assets

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-62 Personal Balance Sheet –Savings rate measures savings over the period in comparison to disposable income over the period Savings rate = Savings during the period Disposable income during the period From personal balance sheet on previous slide $400/$2,500 = 16%

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-63 Relationship Between Cash Flows and Wealth Wealth is built by using net cash flows to invest in assets without increasing liabilities Net cash flows can be used to decrease liabilities which will increase net worth Net worth can change even if net cash flows are zero; for example, the value of an asset or investment increases or decreases

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-64 Financial Planning Online: Budgeting Advice Go to: sellingtools/calculators/budget sellingtools/calculators/budget Click on “How much am I spending?” This Web site provides a means for comparing your actual budget versus your desired budget and shows how you could improve your budget.

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-65 Relationship Between Cash Flows and Wealth Exhibit 2.9: How Net Cash Flows Can Be Used to Increase Net Worth

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-66 How Budgeting Fits within Your Financial Plan The key budgeting decisions for building your financial plan are: –How can I improve my net cash flows in the near future? –How can I improve my net cash flows in the distant future?

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-67 Integrating Key Concepts

Copyright ©2004 Pearson Education, Inc. All rights reserved.2-68 Integrating Key Concepts Part 1: Financial Planning Tools –In Chapter 2 we learned about personal financial statements –Chapter 3 teaches time value of money –Chapter 4 teaches tax planning Part 2: Liquidity Management Part 3: Financing Part 4: Protecting Your Wealth Part 5: Investing Part 6: Retirement and Estate Planning