Week 2 Assignment

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Personal Finance

SIXTH EDITION

Chapter 2

Planning with Personal Financial Statements

Chapter Objectives

2.1 Explain how to create your personal cash flow statement

2.2 Identify the factors that affect your cash flows

2.3 Forecast your cash flows

2.4 Explain how to create your personal balance sheet

2.5 Explain how your personal financial statements fit within your financial plan

Personal Cash Flow Statement (1 of 3)

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

Personal Cash Flow Statement (2 of 3)

Create a statement by recording your revenues and expenses over a period of time

Net cash flows: cash inflows minus cash outflows

Personal Cash Flow Statement (3 of 3)

EXHIBIT 2.1 Personal Cash Flow Statement for Stephanie Spratt
Cash Inflows	Last Month
Disposable (after-tax) income	$2,500
Interest on deposits	0
Dividend payments	0
Total Cash Inflows	$2,500
Cash Outflows	Last Month
Rent	$600
Internet	50
Electricity and water	60
Cellular	60
Groceries	300
Health care insurance and expenses	130
Clothing	100
Car expenses (insurance, maintenance, and gas)	200
Recreation	600
Total Cash Outflows	$2,100
Net Cash Flows	+$400

Factors That Affect Cash Flows (1 of 3)

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

Factors That Affect Cash Flows (2 of 3)

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

Factors That Affect Cash Flows (3 of 3)

Creating a Budget (1 of 8)

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

Creating a Budget (2 of 8)

EXHIBIT 2.3 Stephanie Spratt’s Revised Personal Cash Flow Statement
Cash Inflows	Actual Amounts Last Month	Expected Amounts This Month
Disposable (after-tax) income	$2,500	$2,500
Interest on deposits	0	0
Dividend payments	0	0
Total Cash Inflows	$2,500	$2,500
Cash Outflows	Actual Amounts Last Month	Expected Amounts This Month
Rent	$600	$600
Internet	50	50
Electricity and water	60	60
Cellular	60	60
Groceries	300	300
Health care insurance and expenses	130	[430]
Clothing	100	100
Car expenses (insurance, maintenance, and gas)	200	[500]
Recreation	600	600
Total Cash Outflows	$2,100	$2,700
Net Cash Flows	+$400	-$200

Creating a Budget (3 of 8)

EXHIBIT 2.4 Summary of Stephanie Spratt’s Revised Cash Flows
	Last Month’s Cash Flow Situation	Unusual Cash Flows Expected This Month	This Month’s Cash Flow Situation
Cash inflows	$2,500	$0	$2,500
Cash outflows	$2,100	$600	$2,700
Net cash flows	$400	-$600	–$200

Creating a Budget (4 of 8)

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

Creating a Budget (5 of 8)

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

Go to the website https://money.strands.com/ for an App that will help with this task

Creating a Budget (6 of 8)

EXHIBIT 2.5 Stephanie Spratt’s Revised Personal Cash Flow Statement
Cash Inflows	Expected Amounts (forecasted at the beginning of the month)	Actual Amounts (determined at the end of the month)	Forecasting Error
Disposable (after-tax) income	$2,500	$2,500	$0
Interest on deposits	0	0	0
Dividend payments	0	0	0
Total Cash Inflows	$2,500	$2,500	$0
Cash Outflows	Expected Amounts	Actual Amounts	Forecasting Error
Rent	$600	$600	$0
Internet	50	50	0
Electricity and water	60	60	0
Cellular	60	60	0
Groceries	300	280	+20
Health care insurance and expenses	430	430	0
Clothing	100	170	-70
Car expenses (insurance, maintenance, and gas)	500	500	0
Recreation	600	650	-50
Total Cash Outflows	$2,700	$2,800	–$100
Net Cash Flows	-$200	-$300	-$300

Creating a Budget (7 of 8)

Improving 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

Creating a Budget (8 of 8)

EXHIBIT 2.6 Annual Budget for Stephanie Spratt
Cash Inflows	Typical Month	This Year’s Cash Flows (equal to the typical monthly cash flows × 12)
Disposable (after-tax) income	$2,500	$30,000
Interest on deposits	0	0
Dividend payments	0	0
Total Cash Inflows	$2,500	$30,000
Cash Outflows	Typical Month	This Year’s Cash Flows
Rent	$600	$7,200
Internet	50	600
Electricity and water	60	720
Cellular	60	720
Groceries	300	3,600
Health care insurance and expenses	130	1,560
Clothing	100	1,200
Car expenses (insurance, maintenance, and gas)	200	2,400
Recreation	600	7,200
Total Cash Outflows	$2,100	$25,200
Net Cash Flows	+$400	$4,800 (difference between cash inflows and outflows)

Financial Planning Online (1 of 2)

Go to www.moneycrashers.com/five-steps-to-effective-budgeting

This Web site provides tips on effective budgeting based on your goals.

The Web site https://www.mint.com/ also contains a lot of budgeting information and other financial tools.

Personal Balance Sheet (1 of 15)

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

Financial Planning Online (2 of 2)

Go to http://www.dailyfinance.com /

Search for Calculators

This Web site provides an estimate of the savings you can accumulate over time if you can reduce your spending on one or more of your monthly expenses.

Personal Balance Sheet (2 of 15)

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

Personal Balance Sheet (3 of 15)

Investment (financial assets)

Bonds: certificates issued by borrower, usually firms and government agencies, to raise funds

Stocks: certificates representing partial ownership in a firm

Personal Balance Sheet (4 of 15)

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

Personal Balance Sheet (5 of 15)

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 what you own and what you owe.

Personal Balance Sheet (6 of 15)

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 (7 of 15)

EXHIBIT 2.7 Stephanie Spratt’s Personal Balance Sheet
Assets
Liquid Assets
Cash	$500
Checking account	3,500
Savings account	0
Total liquid assets	$4,000
Household Assets
Home	$0
Car	1,000
Furniture	1,000
Total household assets	$2,000
Investment Assets
Stocks	$3,000
Total investment assets	$3,000
Total Assets	$9,000

Personal Balance Sheet (8 of 15)

EXHIBIT 2.7 Stephanie Spratt’s Personal Balance Sheet
Liabilities and Net Worth
Current Liabilities
Credit card balance	$2,000
Total current liabilities	$2,000
Long-Term Liabilities
Mortgage	$0
Car loan	0
Total long-term liabilities	$0
Total Liabilities	$2,000
Net Worth	$7,000

Personal Balance Sheet (9 of 15)

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…

Note that her assets increase but her liabilities increase by the same amount

Personal Balance Sheet (10 of 15)

EXHIBIT 2.8 Stephanie Spratt’s Personal Balance Sheet if She Purchases a New Car
Assets
Liquid Assets	Present Situation	If She Purchases a New Car
Cash	$500	$500
Checking account	3,500	500
Savings account	0	0
Total liquid assets	$4,000	$1,000
Household Assets
Home	$0	$0
Car	1,000	20,000
Furniture	1,000	1,000
Total household assets	$2,000	$21,000
Investment Assets
Stocks	$3,000	$3,000
Total investment assets	$3,000	$3,000
Total Assets	$9,000	$25,000

Personal Balance Sheet (11 of 15)

EXHIBIT 2.8 Stephanie Spratt’s Personal Balance Sheet if She Purchases a New Car
Liabilities and Net Worth
Current Liabilities
Credit card balance	$2,000	$2,000
Total current liabilities	$2,000	$2,000
Long-Term Liabilities
Mortgage	$0	$0
Car loan	0	16,000
Total long-term liabilities	$0	$16,000
Total Liabilities	$2,000	$18,000
Net Worth	$7,000	$7,000

Personal Balance Sheet (12 of 15)

Impact of the economy on the personal balance sheet

Favorable economic conditions can increase job opportunities and income

Unfavorable economic conditions result in lost jobs and income

Net worth can decline to the point of becoming negative

Relationship Between Cash Flows and Wealth (1 of 2)

How Cash Flows Affect the Personal Balance Sheet

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

Relationship Between Cash Flows and Wealth (2 of 2)

Personal Balance Sheet (13 of 15)

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 slides

4,000/2,000 = 2

Higher liquidity ratio = greater liquidity

Personal Balance Sheet (14 of 15)

Debt level is measured by debt-to-asset ratio

Debt-to-Asset Ratio = Total liabilities/total assets

From personal balance sheet on previous slides

2,000/9,000 = 22.22%

Higher ratio = higher debt relative to assets

Personal Balance Sheet (15 of 15)

Savings rate measures savings over the period in comparison to disposable income over the period

How Budgeting Fits Within Your Financial Plan (1 of 5)

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?

How Budgeting Fits Within Your Financial Plan (2 of 5)

EXHIBIT 2.11 Application of Budgeting Concepts to Stephanie Spratt’s Financial Plan

GOALS FOR A BUDGETING PLAN

1. Determine how I can increase my net cash flows in the near future. 2. Determine how I can increase my net cash flows in the distant future.

ANALYSIS

Present Situation:

Cash Inflows = $2,500 per month

Cash Outflows = $2,100 per month

Net Cash Flows = $400 per month

Estimated Savings per Year = $4,800 ($400 per month×12 months)

How Budgeting Fits Within Your Financial Plan (3 of 5)

EXHIBIT 2.11 Application of Budgeting Concepts to Stephanie Spratt’s Financial Plan
Increase Net Cash Flows by: Increasing my salary? (New job?)	No. I like my job and have no plans to search for another job right now, even if it would pay a higher salary.
Increasing my income provided by my investments?	No. My investments are small at this point. I cannot rely on them to provide much income.
Other? (If yes, explain.)	No.
Reduce Cash Outflows by:
Reducing my household expenses?	No.
Reducing my recreation expenses?	Yes (by $100 per month).
Reducing my other expenses?	No.
Overall, I identified only one adjustment to my budget, which will increase monthly net cash flows by $100.

How Budgeting Fits Within Your Financial Plan (4 of 5)

DECISIONS

Decision to Increase Net Cash Flows in the Near Future:

I initially established a budget to save $4,800 per year. During the next year, I can attempt to save an additional $100 per month by reducing the amount I spend on recreation. I can increase my savings if I reduce cash outflows. By reducing cash outflows by $100 per month, my savings will increase from $400 to $500 per month. The only way that I can reduce cash outflows at this point is to reduce the amount I spend for recreation purposes.

EXHIBIT 2.11 Application of Budgeting Concepts to Stephanie Spratt’s Financial Plan

How Budgeting Fits Within Your Financial Plan (5 of 5)

Decision to Increase Net Cash Flows in the Distant Future:

My cash inflows will rise over time if my salary increases. If I can keep my cash outflows stable, my net cash flows (and therefore my savings) will increase. When I buy a new car or a home, my monthly cash outflows will increase as a result of the monthly loan payments. If I buy a new car or a home, I need to make sure that I limit my spending (and therefore limit the loan amount) so that I have sufficient cash inflows to cover the monthly loan payments along with my other typical monthly expenses.

If I get married someday, my husband would contribute to the cash inflows, which would increase net cash flows. We would be able to save more money and may consider buying a home. If I marry, my goal will be to save even more money per month than I save now, to prepare for the possibility of raising a family in the future.

EXHIBIT 2.11 Application of Budgeting Concepts to Stephanie Spratt’s Financial Plan