Budgets and Balance Sheets: Your Personal Financial Statements Chapter 4 Budgets and Balance Sheets: Your Personal Financial Statements © 2010 Pearson Education, Inc. All rights reserved

Learning Objectives Explain the steps involved in creating a budget Explain the steps involved in creating a personal balance sheet Analyze the importance of budgeting in your financial plan © 2010 Pearson Education, Inc. All rights reserved

Creating a Budget 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 A budget is a forecast of future cash inflows and outflows Discuss the importance of creating an accurate budget. A budget is the foundation of a financial plan. Explain how a budget is not a negative thing. It empowers you to have the things you want. © 2010 Pearson Education, Inc. All rights reserved

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 Discuss the importance of monitoring and recording your cash flows. © 2010 Pearson Education, Inc. All rights reserved

Figure 4.1 © 2010 Pearson Education, Inc. All rights reserved

Step 2: Turning 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 Ask students what cash flows they currently have. Will any change in the near future? © 2010 Pearson Education, Inc. All rights reserved

Step 2: Turning 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 Explain how it is important to forecast for everything – ATM fees, coffee, etc – this helps in creating an accurate budget Give examples of unexpected expenses such as car breakdowns or medical emergencies © 2010 Pearson Education, Inc. All rights reserved

Figure 4.2 © 2010 Pearson Education, Inc. All rights reserved

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 © 2010 Pearson Education, Inc. All rights reserved

Assessing the Accuracy of the Budget 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 A forecast error is the difference between what you forecast to happen and what actually happened Explain how it is important to monitor your budget because errors can occur and need to be fixed. Explain how you might need to increase your income or decrease your outflow to fix these errors. © 2010 Pearson Education, Inc. All rights reserved

Figure 4.3 © 2010 Pearson Education, Inc. All rights reserved

Check Your Financial IQ What are the steps involved in creating a budget? © 2010 Pearson Education, Inc. All rights reserved

Check Your Financial IQ 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 © 2010 Pearson Education, Inc. All rights reserved 0-13

Personal Balance Sheet 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 Personal balance sheet tells you what your financial position is at a point in time. Discuss the importance of a balance sheet in regard to your financial plan. © 2010 Pearson Education, Inc. All rights reserved

Assets Assets on a balance sheet can be classified in several ways: Liquid assets Household assets investments Explain why it is important to list your assets on a balance sheet. It helps you figure out where you are financially. © 2010 Pearson Education, Inc. All rights reserved

Liquid Assets 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 Liquid assets are financial assets that are either cash or can be easily converted to cash without significant loss of value Explain how you want to increase your liquid assets. Explain that most savings accounts include an interest rate that will increase your savings. © 2010 Pearson Education, Inc. All rights reserved

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 43,200 How much does Jeff have in liquid assets? © 2010 Pearson Education, Inc. All rights reserved

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. © 2010 Pearson Education, Inc. All rights reserved

Household Assets 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 Household assets include those assets owned by a household – cars, houses, furniture The market value of something is what it would be worth if you sold it today Explain how to estimate market value and how it’s important to understand that what you pay for something isn’t necessarily what it’s worth. Remind students that it is important for a financial plan to be accurate and realistic © 2010 Pearson Education, Inc. All rights reserved

Investments Investments are the third major category of assets An investment is 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 Explain that an investment is something you put your money into with the hopes of making more money. © 2010 Pearson Education, Inc. All rights reserved

Investments 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 Bonds are basically certificates that function like IOUs—promises to repay a certain amount of money at some future time Explain what risks may be involved with bonds (issuer not returning money) © 2010 Pearson Education, Inc. All rights reserved

Investments Stocks are 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 Explain how stocks work. You buy a stock at a certain price. The value can increase or decrease. If it increases and you sell, you make money. If it decreases, you lose money. © 2010 Pearson Education, Inc. All rights reserved

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? © 2010 Pearson Education, Inc. All rights reserved

Math for Personal Finance Solution: Company Y 50 x $170 = $8,500 Company Z 65 x $47 = $3,055 Total = $11,555 © 2010 Pearson Education, Inc. All rights reserved

Investments 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 Mutual funds are created so investors can pool their money in order to invest in a larger variety of financial assets, such as stocks and bonds from many different companies Explain how mutual funds work. Explain how the risk of loss isn’t as risky since it is spread across a few investments. © 2010 Pearson Education, Inc. All rights reserved

Investments Real estate is another type of investment Real estate includes 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 Explain why people invest in real estate. People buy real estate and sell it hoping the value has increased and they will make a profit. © 2010 Pearson Education, Inc. All rights reserved

Liabilities Liabilities represent the amount of debt a person owes These debts can be put into 2 categories: Current liabilities Long-term liabilities © 2010 Pearson Education, Inc. All rights reserved

Liabilities Current liabilities are 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 of every month When you pay the credit card bill, you are eliminating the current liability Explain that current liabilities are a short term “loan” that should be paid off fairly soon. © 2010 Pearson Education, Inc. All rights reserved

Liabilities Long-term liabilities are 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 Explain that for most long term liabilities, there is the initial amount (principal) and these will have an interest on them, costing you more money than the initial amount. © 2010 Pearson Education, Inc. All rights reserved

Net Worth Net worth is 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 Explain that net worth can be negative if there are more liabilities than assets. © 2010 Pearson Education, Inc. All rights reserved

Figure 4.4 © 2010 Pearson Education, Inc. All rights reserved

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? © 2010 Pearson Education, Inc. All rights reserved

Math for Personal Finance Solution: Lakisha’s net worth is $6,000 - $1,200 - $450 = $4,350 © 2010 Pearson Education, Inc. All rights reserved

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 The value of your assets needs to increase by more than your liabilities To pay down debt on your liabilities Tell students to make updates to their budget as their personal balance sheet changes. © 2010 Pearson Education, Inc. All rights reserved

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 Explain that if you have more debt (liabilities) than assets, you might not get a loan. © 2010 Pearson Education, Inc. All rights reserved

Check Your Financial IQ What are the steps in creating a personal balance sheet? © 2010 Pearson Education, Inc. All rights reserved

Check Your Financial IQ To see your net worth, you need to identify all your assets, identify all your liabilities, and then subtract your liabilities from you assets. 0-37 © 2010 Pearson Education, Inc. All rights reserved

Budgeting and Your Financial Plan Your cash flows feed into your balance sheet If cash flows 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 Remind students that cash inflows is money that is coming “in”. Cash outflows is money that is going “out” – spending. © 2010 Pearson Education, Inc. All rights reserved

Figure 4.5 © 2010 Pearson Education, Inc. All rights reserved

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? Explain that net cash flows means money coming in/money that you have. © 2010 Pearson Education, Inc. All rights reserved

Check Your Financial IQ What is the importance of budgeting to your financial plan? © 2010 Pearson Education, Inc. All rights reserved

Check Your Financial IQ Budgeting helps you evaluate your current financial condition and determine how to improve net cash flows and make wise credit, borrowing, and investment decisions. © 2010 Pearson Education, Inc. All rights reserved 0-42

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 © 2010 Pearson Education, Inc. All rights reserved

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 © 2010 Pearson Education, Inc. All rights reserved

Summary Budgeting can help you manage your cash flows to increase your net worth You can use this in building a financial plan 0-45 © 2010 Pearson Education, Inc. All rights reserved

Vocabulary 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 © 2010 Pearson Education, Inc. All rights reserved

Websites www.forbes.com www.kbb.com (Kelley Blue Book) © 2010 Pearson Education, Inc. All rights reserved