Planning Your Financial Future, 4eby: Boone, Kurtz & Hearth

Personal Financial Statements and

Budgets

Chapter 3

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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

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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

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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

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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

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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

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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

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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

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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.

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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

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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

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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

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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

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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

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Figure 3.3: Median Household Net Worth in the United States

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Figure 3.3: Median Household Net Worth in the United States

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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

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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

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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

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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

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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

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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

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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 onesA budget should never deprive you of what

you need It should support your short- and long-term

goals

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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

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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

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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

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Figure 3.7: Distribution of Consumer Spending

Source: Based on data from the Statistical Abstract of the United States.

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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

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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

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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