Chapter 3 Planning with Personal Financial Statements Copyright © 2012 Pearson Canada Inc. Edited by Laura Lamb, Department of Economics, TRU 3-1.

Chapter 3

Planning with Personal Financial

Statements Copyright © 2012 Pearson Canada Inc.Edited by Laura Lamb, Department of

Economics, TRU

3-1

Chapter Objectives

• Explain how to create your personal cash flow statement

• Identify the factors that affect your cash flows

• Explain how to create a budget based on your forecasted cash flows

• Describe how to create your personal balance sheet

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Personal Cash Flow Statement

• The first step in the budgeting process is to create a personal cash flow statement

• Personal cash flow statement: a financial statement that measures a person’s income and expenses

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Personal Cash Flow Statement

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Personal Cash Flow Statement

• Net cash flows: Disposable (after-tax) income minus expenses

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Factors That Affect Cash Flow

• What factors affect income?

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Income & Age

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Factors That Affect Cash Flow (cont’d)

• What factors affect expenses?

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Creating a Budget• Budget: a cash flow statement that is

based on forecasted cash flows (income and expenses) for a future time period

• Why are budgets useful?

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Creating a Budget • Anticipating Cash Shortages• Small shortages can usually be made up from

your chequing account or an emergency fund

• 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 and take any necessary steps to improve your cash flow

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Creating a Budget (cont’d)

• 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 prescription drugs, car and home maintenance

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Creating a Budget (cont’d)

• Budgeting with a Biweekly Pay Period

• A biweekly pay structure will result in an individual receiving an additional paycheque twice a year

• Extra pay periods provide an opportunity to increase your savings inside an emergency fund or a long-term savings plan

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Creating a Budget (cont’d)

• Creating an Annual Budget

• Create an annual budget by extending your budget out for longer periods

• Large changes in cash flow could be the result of changes in income and/or expenses

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Creating a Budget (cont’d)

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Creating a Budget (cont’d)

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Creating a Budget (cont’d)

• 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

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Creating a Budget (cont’d)

• Alternative Budgeting Strategies• Envelope Method

• Forces you to stick to a cash-only budget for the expense categories that are hardest to control

• Create a separate envelope for each category• Place the budgeted cash amount in each envelope• You can spend only the money in the envelope for the

assigned category• Balances can be carried forward

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Creating a Budget (cont’d)

• Alternative Budgeting Strategies• Pay Yourself First Method

• Arrange for an automatic transfer of money from your chequing account to your savings account

• Transfer would coincide with when you receive your paycheque

• In contrast to the envelope method, this method removes net cash flows at the beginning of the budget period

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Creating a Budget (cont’d)

• Focus on Ethics: Excessive Financial Dependence

• Don’t become overly dependent on others

• Can create tension and ultimately destroy relationships

• Create a budget and stay within it

• Build and maintain an emergency fund

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Personal Balance Sheet

• Personal balance sheet: a summary of your assets, your liabilities, and your net worth

• A personal balance sheet reflects your financial position at a specific point in time

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Personal Balance Sheet (cont’d)

• Assets

• Liquid assets

• Household assets

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Personal Balance Sheet (cont’d)

• Investments

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

• Stocks: certificates representing partial ownership in a firm

• Mutual funds: investment companies that sell units to individuals and invest the proceeds in an overall portfolio of investment instruments such as bonds or stocks

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Personal Balance Sheet (cont’d)• Real estate: holdings in rental property and land

• Rental property: housing or commercial property that is rented out to others

• Liabilities– Current liabilities

– Long-term liabilities

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Personal Balance Sheet (cont’d)

• Net worth:

• Value of total assets – Value of total liabilities

• A measure of wealth

• Closely related to your life stage (e.g., early earning vs. prime earning)

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Personal Balance Sheet (cont’d)

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Personal Balance Sheet (cont’d)

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Personal Balance Sheet (cont’d)

• How Cash Flows Affect the Personal Balance Sheet

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Personal Balance Sheet (cont’d)

• 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

• High liquidity ratio higher degree of liquidity

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Personal Balance Sheet (cont’d)

• Debt level is measured by debt-to-asset ratio

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

• High debt-to-asset ratio excessive amount of debt

• Should be directly related to the financial planning life stages

• Should have no debt when you reach the retirement life stage

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Personal Balance Sheet (cont’d)

• 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

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