Chapter 2 Using Financial Statements and Budgets How Will This Affect Me? A recent survey shows that more than half of adult Americans could not cover six months of living expenses or the cost of medical emergencies. And younger millennials between the ages of 18 to 24 are the least prepared. This is scary . . . and this chapter explains what you can do to avoid being part of that alarming statistic. Everyone knows it’s hard to get where you need to go if you don’t know where you are. Financial goals describe your destination, and financial statements and budgets are the tools that help you determine exactly where you are in the journey. This chapter helps you define your financial goals and explains how to gauge your progress carefully over time. Hopefully most of your students have had a semester of financial accounting. If so, while this chapter will be a review for them, they may need help understanding the differences between cash and accrual accounting. The chapter deals with cash accounting; the previous accounting course dealt with accrual accounting. If they have not had an accounting course, the students may have a hard time. If this material is new to them, it will be helpful if you go over worksheets (2.1 and 2.2) and then discuss the Financial Planning Exercises 3 (preparing a personal balance sheet) and 4 (preparing a personal income and expense statement). The Facts or Fantasies are true false questions designed to create interest in the chapter. They are below and in the power points for the chapter. Learning Goals LG 2-1 Understand the relationship between financial plans and statements. The statement above “it’s hard to get where you need to go if you don’t know where you are” is very true. The financial statements help you to understand where you are. If not consistent with your financial goal, you know you need to make some changes. To get a feel for where your students are in their ability to account for their financial transactions, ask the students if they have a checking account. Then ask them if they know the balance of that account. Exhibit 2.1 presents the impact of the financial statements on the financial plan. The statements give feedback to the plan. LG 2-2 Prepare a personal balance sheet. The Balance Sheet computes the net worth as of a given date. The Balance sheet formula [Total Assets = Total Liabilities + Net Worth] may be useful especially to students who are number people. By comparing the current balance sheet with the previous one from a year ago, you can see if you are moving toward your goal, or not. While liquid assets and investments may look the same, their purpose is very different. The liquid assets are available to spend or pay off debt, while the investments are for the long term. Recall that here we are discussing a personal balance sheet. Therefore, the concept of depreciation is not the same as with generally accepted accounting principles (GAAP). With GAAP, depreciation is the allocation of a past cost over its useful life. With a personal balance sheet, depreciation is a decline in value – the assets are stated at their market value. Fair market value may mean different amounts depending upon your market. The value to use is the amount you can get if you sell your assets. Thus, personal property such as furniture may be valued very low compared to the purchase price. Your market may be a garage sale. It is common for personal property to decline in value and real property to increase in value – though it is not guaranteed. Liabilities are amounts owed to others. The classification as current [due within one year] and long-term is important. The current liabilities have to be paid in the short run, while long-term liabilities may be paid in the future or be paid with a monthly payment – which is a current liability. Worksheet 2.1 gives a format for a personal balance sheet—a fill-in-the-blanks approach that is useful for financial planning. Exhibit 2.2 gives the student hope that in the future they will have a net worth. While not important to monitor the financial plan, to maintain the balance sheet equation [A=L+E] you need to add a Valuation Allowance to the Equity section. Thus, if you purchase a new car for $20,000, when you get it home the sales value is probably only $18,000. To record the car on your balance sheet, the net realizable value is $18,000, cash is reduced by $20,000 [or liabilities increase] and the balancing entry [$2,000] is to the valuation allowance. LG 2-3 Generate a personal income and expense statement. While the balance sheet reports financial position as of a given day, the income statement covers a stated period, typically a month, quarter, or year. A useful exercise is to ask the class “is income gross pay or net pay?” If you take the position that it is net pay, you are saying that you have no control over the payroll deductions. But you can control at least some of them, and any control you exercise should be consistent with your financial plan. You decide how many exemptions to claim for income taxes. You may have some choice as to what health insurance you select, what life insurance to select, or perhaps other benefits such as child care or additional health benefits. “Income” is defined in the text by giving examples of income items. Income may be defined as an increase in assets with no obligation to pay it back. Thus, for a personal income and expense statement, a birthday gift of $100 is income while on a GAAP statement, it is a contribution to paid-in capital. Proceeds from a loan is not income, there is an offsetting obligation to pay back. Worksheet 2.2 lists the typical income and expenses items. The example for Lily and Jack Taylor gives the students an example of an income and expense statement. Exhibit 2.3 gives average annual expenditures that the student can use to compare their experience. Of course, your students are like those from Lake Wobegon and are above average: Good or Bad? LG 2-4 Develop a good record-keeping system and use ratios to evaluate personal financial statements. Without records, you are flying blind. It like the person who says they can spend money as long as they have a check in their checkbook. Records give you a way to prepare financial reports which allow you to evaluate where you are on your financial plan. There is inexpensive software that will help you keep records, but you still have to record the transactions in order to have data for your financial statements. With financial statements you may use ratio analysis to better understand how you are doing. Exhibit 2.4 gives a list of useful ratios. It will be useful to do some sensitivity analysis, that is, ask the students is it good or bad to move from a solvency ratio of 35% to 50%; liquidity ratio from 13% to 8%; and so on. This will help student understand the information in the ratio. LG 2-5 Construct a cash budget and use it to monitor and control spending. The income statement reports the cash surplus or deficit for the period. But is the surplus of $2,000 good or not. You need something to compare it to. Frequently you compare to the previous period. While that is better than no comparison, comparing to your planned surplus is better. Your planned surplus is the bottom line of your budget. The budget is a statement in dollars of your planned income and expenses for the period, typically month or year. By comparing the current expenses with budgeted expenses, you create a budget variance. That variance tells you if you need to hold the course or change your direction. The actual income or expense compared to the budgeted amount gives you the ability to monitor and control your expenses. Preparing, analyzing, and monitoring your personal budget are essential steps for successful personal financial planning. Worksheet 2.3 gives a common format for a cash budget, your planned expenditures for the year. The cash budget for Jack and Lily Taylor is an example. Worksheet 2.4 gives an example of comparing actual to budget and the resulting variance. LG 2-6 Apply time value of money concepts to put a monetary value on financial goals. Financial plans are concerned with what future amounts you will need to be able to provide for your desired lifestyle at that time. Since the time is in the future, typically you need to apply the concept called the time value of money, the idea that a dollar today is worth more than a dollar received or spent in the future. Hopefully your students have been exposed to this concept in previous courses. If not, use short time periods [3 or 5 years] to demonstrate the concept. Perhaps use financing of a car as an example: You can pay $20,000 today or $400 per month for 5 years. With a 6% annual rate, the present value of an annuity of $400 per month, for 60 months, at .06/12 monthly rate, is $20,690. If you are OK with a 6% rate, pay cash. The book discusses using a financial calculator. You could discuss spreadsheets [Excel] financial functions such as PV, DCF, FV, or IRR. It depends upon the culture of your program whether you use calculators or spreadsheets. The Rule of 72 is very useful for quick comparisons. Discuss it. LG 2-7 Understand the relationship between inflation and nominal interest rates and calculate the real interest rate. Inflation is arguably the most prominent source of investment risk and is a key driver of interest rates. It is important to understand the effect of inflation, how inflation affects interest rates, and how best to handle inflation in key financial planning problems. Interest rates may be a nominal rate [unadjusted for inflation] or a real interest rate [adjusted for inflation]. The real rate may be approximated by subtracting the expected rate of inflation from the nominal rate of an investment. For example, in an investment of $10,000 will earn 8% for a year where you expect 3% inflation, the approximate real return on the investment in 8% - 3% = 5%. A more accurate computation of the real rate of interest is given by the Fisher equation. (1+in) = (1+ireal) * (1+iinf); ireal =[ (1+in) / (1+iinf)] – 1 The ireal may be used in computing the return on investments that result from your financial plans. Financial Facts or Fantasies? These may be used as “teasers” to get the students on the right page with you. Also, they may be used as quizzes after you covered the material or as “pre-test questions” to get their attention. • Whereas the balance sheet summarizes your financial condition at a given point in time, the income and expense statement reports on your financial performance over time. Fact: A balance sheet is like a photograph of your financial condition (covering just one day out of the year), while an income and expense statement is like a motion picture (covering the full year or some other time period). • Because financial statements are used to record actual results, they’re really not that important in personal financial planning. Fantasy: Personal financial statements let you know where you stand financially. As such, they not only help you set up realistic financial plans and strategies but also provide a system for monitoring the amount of progress you’re making toward the financial goals you've set. • A leased car should be listed as an asset on your personal balance sheet. Fantasy: You are only “using” the leased car and do not own it. Consequently, it should not be included as an asset on the balance sheet. • Only the principal portion of a loan should be recorded on the liability side of a balance sheet. Fact: The principal portion of a loan represents the unpaid balance and is the amount of money you owe. In contrast, interest is a charge that will be levied over time for the use of the money. • Generating a cash surplus is desirable, because it adds to your net worth. Fact: You can only increase your net worth by generating a cash surplus, someone giving you additional assets, or through increases in market values. The only one of the three you control is generating cash surplus. • When evaluating your income and expenses statement, primary attention should be given to the top line: income received. Fantasy: If you focus on only income and ignore expenses, you will quickly find yourself with a cash deficit and your net worth will decrease. Expenses are equally important and must be controlled. Financial Facts or Fantasies? These may be used as a quiz or as a pre-test to get the students interested. 1. True False Whereas the balance sheet summarizes your financial condition at a given point in time, the income and expense statement reports on your financial performance over time. 2. True False Because financial statements are used to record actual results, they’re really not that important in personal financial planning. 3. True False A leased car should be listed as an asset on your personal balance sheet. 4. True False Only the principal portion of a loan should be recorded on the liability side of a balance sheet. 5. True False Generating a cash surplus is desirable, because it adds to your net worth. 6. True False When evaluating your income and expenses statement, primary attention should be given to the top line: income received. Answers: 1. True 2. False 3. False 4. True 5. True 6. False YOU CAN DO IT NOW The “You Can Do It Now” cases may be assigned to the students as short cases or problems. They will help make the topic more real or relevant to the students. In most cases, it will only take about ten minutes to do, that is, until the student starts looking around at the web site. But they will learn by doing so. Track Your Expenses It's easy for spending to become so automatic that we're not aware we're doing it. So where does your money go? The only way to find out is to keep track of it. Writing down what you spend in a paper journal or using an app like Expensify (www.expensify.com) is simple and will make you more aware of where your money goes. Knowing where you are will probably make you feel better too - so do it now. Save Automatically We all know we should save regularly. One way to create a savings "habit" is to literally make it automatic. Open a savings account apart from your checking account. This will separate your savings from what you have available to spend. And then set up an automatic deposit or transfer from your checking account to your savings account each month. This sets your "habit." You can do it now. Financial Impact of Personal Choices Read and think about the choices being made. Do you agree or not? Ask the students to discuss the choices being made. No Budget, No Plan: Tyler Bought a Boat! Tyler is 28 and has a good job as a sales rep. He's always found budgeting boring and has been intending to start a financial plan for years. Recently Tyler went out with some friends on a rented boat to fish. He had a great time and saw a boat for sale on his way home. Before he knew it, the salesman convinced Tyler that the deal was just too good to pass up. So Tyler bought a $10,000 boat and financed 80 percent of the cost for the next 5 years. Sean now finds himself relying more on his credit card to get by each month. What if Tyler had kept track of his money, used a budget, and had a set of financial goals? Knowing where his money went and having a financial plan would have increased the chance that Tyler would make more deliberate, informed financial decisions. Solutions to Financial Planning Exercises 1. Financial plans v statements: Describe and distinguish financial plans and statements. Financial plans describe financial goals provide action plans for their achievements. They are future oriented. Financial statements report the results of financial activities [income and expense statement] for the past time period [month or year] and the financial position at the end of that time period [balance sheet]. The statements are past oriented. 2. Preparing Financial Statements: Hugo Garcia is preparing his balance sheet and income and expense statement for the year ending December 31, 2020. He is having difficulty classifying seven items and asks for your help. Which, if any, of the following transactions are assets, liabilities, income, or expense items? a. Hugo rents a house for $1,350 a month. The monthly rent is a monthly expense. The payment will reduce an asset, Cash. b. On June 21, 2020, Hugo bought diamond earrings for his wife and charged them using his Visa card. The earrings cost $900, but he hasn’t yet received the bill. The purchase will result in a new asset, personal property for $900. Since he purchase using a credit card, his current liabilities also increase by $900. c. Hugo borrowed $3,500 from his parents last fall, but so far, he has made no payments to them. Since no loan payments were made during the period, a corresponding expense would not appear. Whether or not the “loan” is a real loan or a gift from the parents is a question of fact to be determined. If real loan, the balance sheet will list a liability of $3,500. If a gift, the amount will be income and net worth will increase by the amount of cash received. d. Hugo makes monthly payments of $225 on an installment loan; about half of it is interest, and the balance is repayment of principal. He has 20 payments left, totaling $4,500. The income statement will show an expense: payment of loan $225 per month times 12 months, a total for the year of $2,700. When a balance sheet is prepared, the loan balance will be reduced by half of the 225 per month which represent payment of principal. e. Hugo paid $3,800 in taxes during the year and is due a tax refund of $650, which he hasn’t yet received. The payment of taxes is an expense recorded as paid, typically monthly or when paycheck is received. The refund is not recorded on the income statement until it is received. The receivable is not recorded on a cash basis balance sheet. f. Hugo invested $2,300 in a mutual fund. The cash asset goes down and the asset investment goes up. The investment will appear on the balance sheet, but there is no report on the Income and Expense Statement. g. Hugo’s Aunt Lydia gave him a birthday gift of $300. The gift increases his cash account and he has no obligation to repay. So, the amount is reported on his income and expense statement as income. It should be listed at the bottom of the statement since it is not a recurring item. Also, it is common for relatives to give young relations cash gifts, so if it is not reported Hugo’s income statement will not reflect his increase in cash for the period. Under GAAP, gifts to a business entity are contributions to capital and do not appear on an income statement. But for a personal non-GAAP income statement, the gift should be reported on the income statement. Since it is a non-recurring item, the gifts will not be considered by lenders as continuing income. 3. Preparing Personal Balance Sheet: Use Worksheet 2.1 Katie Wright’s banker has asked her to submit a personal balance sheet as of June 30, 2020, in support of an application for a $6,000 home improvement loan. She comes to you for help in preparing it. So far, she has made the following list of her assets and liabilities as of June 30, 2016: From the data given, prepare Katie Wright’s balance sheet, dated June 30, 2020 (follow the balance sheet form shown in Worksheet 2.1). Then evaluate her balance sheet relative to the following factors: (a) solvency, (b) liquidity, and (c) equity in her dominant asset. See following page for Worksheet 2.1 for Denise Fisher. 3-a. Solvency Ratio: This term refers to having a positive net worth. The calculation for her solvency ratio is as follows: This indicates that Katie could withstand about a 35% decline in the market value of her assets before she would be insolvent. Although this is not too low a value, some thought might be given to increasing her net worth. 3-b. Liquidity: A simple analysis of Katie’s balance sheet reveals that she's not very liquid. In comparing current liquid assets ($900) with current bills outstanding ($1,700), it is obvious that she cannot cover her bills and is, in fact, $800 short (i.e., $1,700 current debt – $900 current assets). Her liquidity ratio is: This means she can cover only about 53% of her current debt with her liquid assets. Rule of thumb, the liquidity ration should be at least 1. If we assume that her installment loan payments for the year are about $2,000 (half the auto loan balance and all of the furniture loan balance) and add them to the bills outstanding, the liquidity ratio at this level of liquid assets is: This indicates that should her income be curtailed, she could cover only about 24% of her existing one-year debt obligations with her liquid assets—and this does not include her mortgage payment! This is clearly not a favorable liquidity position. 3-c. Equity in her Dominant Asset: Katie’s dominant asset is her condo and property, which is currently valued at $68,000. Since the loan outstanding on this asset is $52,000, the equity is $16,000 (i.e., $68,000 – $52,000). This amount indicates about a 24% equity interest (i.e., $16,000/$68,000) in the market value of her real estate. This appears to be a favorable equity position. 4. Preparing Income and Expense Statement: Use Worksheet 2.2. Robyn and Matthew Scott are about to construct their income and expense statement for the year ending December 31, 2020. They have put together the following income and expense information for 2020: Using the information provided, prepare an income and expense statement for the Scotts for the year ending December 31, 2020 (follow the form shown in Worksheet 2.2). See worksheet on following page. Issues: Purchase of bonds is a balance sheet transaction, a non-recurring conversion of cash to investment in bonds. There is no expense; there is no impact on net worth. The payment of the auto loan could be left off the expense statement since it is a reduction of an asset and a liability. However, the loan payment is a recurring item and reporting it as an expense helps explain the change in cash. The determining factor is the recurring nature and impact on net worth. The goal of all financial statements is to provide information. If the reader of the statement needs to know about a transaction, that transaction should be on the financial statement. Robyn’s travel expenses are offset by the reimbursement. There is no impact on net worth. However, it is a recurring transaction and reporting it helps explain the change in the cash account. Reporting the expense may also remind Robyn of an item that has not been reimbursed. 5. Preparing Cash Budget: Theo and Sophia Martinez are preparing their 2021 cash budget. Help the Martinez family reconcile the following differences, giving reasons to support your answers. a. Their only source of income is Theo’s salary, which amounts to $5,000 a month before taxes. Sophia wants to show the $5,000 as their monthly income, whereas Theo argues that his take-home pay of $3,917 is the correct value to show. Like many questions it depends. If the taxes and other payroll deductions are considered out of their control, then only the take home pay would be listed. But, since they have some options in the computation of payroll deductions, the gross pay should be listed. Among the options is the number of exemptions for income tax withholding, the option to purchase health insurance for the non-working spouse through the employer or elsewhere, and perhaps other fringe benefits such as child care, flexible benefits, and other. Also, the taxes withheld is a major item of expense and should be listed on the expense statement. To help better understand their source of cash, the withholdings could be listed directly under the gross salary. b. Sophia wants to make a provision for fun money, an idea that Theo cannot understand. He asks, “Why do we need fun money when everything is provided for in the budget?” By having an allowance for "fun money," the Martinez family have specifically set aside a certain portion of their income for a little self-indulgence. This will serve three basic purposes: (1) it will give a little financial independence to each member of the family; (2) to a certain extent it allows for a little impulse buying which might further the enjoyment of life. However, it allows for this luxury under a budget control and diminishes the possibility of it occurring with an allocation from another account; and (3) it generally promotes a higher quality of life. Thus, the inclusion of "fun money" is justified. PLEASE NOTE: Problems 6 through 8 deal with time value of money, and solutions using both the tables and the financial calculator will be presented. The factors are taken from the tables as follows: future value–Appendix A; future value annuity–Appendix B; present value–Appendix C; present value annuity–Appendix D. If using the financial calculator, set on End Mode and 1 Payment/Year. The +/- indicates the key to change the sign of the entry, in these instances from positive to negative. This keystroke is required on some financial calculators in order to make the programmed equation work. Other calculators require that a "Compute" key be pressed to attain the answer. 6. Calculating present and future values: Use future or present value techniques to solve the following problems. a. If you inherited $45,000 today and invested all of it in a security that paid a 7 percent rate of return, how much would you have in 25 years?
FV = PV x FV factor 7%, 25 yrs. (1+i)n 45000 +/- PV
= $45,000 x 5.427 7 I
= $244,215 25 N
FV $244,234.47
b. If the average new home costs $275,000 today, how much will it cost in 10 years if the price increases by 5 percent each year?
FV = PV x FV factor 5%, 10 yrs. (1+.05)10 275000 +/- PV
= $275,000 x 1.629 5 I
= $447,975 10 N
FV $447,946.02
c. You forecast that in 15 years, it will cost $190,000 to provide your child with a 4-year college education. Will you have enough if you take $75,000 today and invest it for the next 15 years at 4 percent? No, you will have $135,071, which is less than your $190,000 goal.
FV = PV x FV factor 4%, 15 yrs. 75000 +/- PV
= $75,000 x 1.801 4 I
= $135,071 15 N
FV $135,070.76
d. If you can earn 4 percent, how much will you have to save each year if you want to retire in 35 years with $1 million? You will need to invest $13,577.55 at the end of each year at a rate of 4% for the next 35 years in order to retire with $1 million.
PMT = FV FVA factor 4%, 35 yrs. 1000000 +/- FV
= $1,000,000 73.651 4 I
= $13,577.55 35 N
Excel 1,000,000 / FV(.04,35,1) PMT $13,577.32
7. Funding a retirement goal: Austin Miller wishes to have $800,000 in a retirement fund 20 years from now. He can create the retirement fund by making a single lump-sum deposit today. a. If upon retirement in 20 years, Austin plans to invest $800,000 in a fund that earns 4 percent, what is the maximum annual withdrawal he can make over the following 15 years? You will be able to withdraw $71,952.88 at the end of each year for 15 years if you retire with $800,000 invested at 4%.
PMT = PV PVA factor 8%, 25 yrs. 800000 +/- PV
= $800,000 11.12 4 I
= $71,952.88 15 N
Excel pmt(.04,15,800000) PMT $71,952.88
b. How much would Austin need to have on deposit at retirement in order to withdraw $35,000 annually over the 15 years if the retirement fund earns 4 percent?
PV = A * PVA factor 4%,15 yrs 35000 +/- PV
PV = $35,000 * 11.12 = $398,200 4 I
15 N
Excel PV = (.04,15,35000) = $389,143.56 FV $389,143.56
c. To achieve his annual withdrawal goal of $35,000 calculated in part b., how much more than the amount in part a. must Austin deposit today in an investment earning 4 percent annual interest. Stated otherwise, how much must Austin invest today to have $389,143 in 20 years if the investment will earn 4%. FV factor 4%, 20 years is 1.04^20 = 2.191 PV = FV / FV factor = 389,143 / 2.191 = $171,600 Since in part a, he had $800,000, he does not need any additional amount. He is well covered. 8. Inflation and Interest Rates: Jessica Adams is 21 years old and has just graduated from college. In considering the retirement investing options available at her new job, she is thinking about the long-term effects of inflation. Help her by answering the following related questions. a. Explain the effect of long-term inflation on meeting retirement financial planning goals. Inflation is one of the most prominent source of investment risk and is a key driver of interest rates. Inflation reduces the purchasing power of cash flows produced by an investment. The impact of real rate of return may be approximated by subtracting the inflation rate from the return on investment. For example, if an investment is expected to earn 8% and inflation is expected to be 3%, the approximate real rate of return is only 5 percent. Of course if you have debt, inflation results in your ability to repay the debt with inflated dollars such that you real rate of interest on the debt is reduced by inflation. b. If long-term inflation is expected to average 4 percent per year and you expect a long-term investment return of 7 percent per year, what is your long-term expected real rate of return (adjusted for inflation)? Be sure to consider the important impact of compounding. The approximate real rate of return is nominal rate of 7% - expected inflation of 4% or 3%. But this does not consider compounding. The Fisher equation considers compounding of interest. Real rate of return = [(1 + in) / (1 + iinf)] – 1; here [1.07 / 1.04] – 1 = 2.88% Solutions to “Test Yourself” Legacy Questions 2-1 What are the two types of personal financial statements? What is a budget, and how does it differ from personal financial statements? What role do these reports play in a financial plan? Personal financial statements provide important information needed in the personal financial planning process. The balance sheet describes your financial condition [that is what assets and liabilities you have] at one point in time. The income and expense statement measures financial performance [cash surplus or deficit] over a given time period typically monthly or annually. Budgets help you plan your future spending. The budget is a statement of the future income or expenses that will result from your financial plan. By comparing the actual income and expenses to the budget you can see when your plan needs to be modified. Together these statements give you information needed for your financial planning process. 2-2 Describe the balance sheet, its components, and how you would use it in personal financial planning. Differentiate between investments and real and personal property. The balance sheet summarizes your financial position by showing your assets (what you own listed at fair market value), your liabilities (what you owe), and your net worth (the difference between assets and liabilities) at a given point in time. With a balance sheet, you know whether your assets are greater than your liabilities, and by comparing balance sheets for different time periods, you can see whether your net worth is growing. Investments are intangible assets that have market value [such as stock] and you hold in hypes of future increases in value and future income. Real property is an asset that is affixed to the ground, example is a house. Personal property is tangible property that is not real property, example is a car or furniture. 2-3 What is the balance sheet equation? Explain when a family may be viewed as technically insolvent. The balance sheet equation is: Net Worth = Total Assets - Total Liabilities A family is technically insolvent when their net worth is less than zero. This indicates that the amount of their total liabilities is greater than the fair market value of their total assets. 2-4 Explain two ways in which net worth could increase (or decrease) from one period to the next. There are basically two ways to achieve an increase in net worth. First, one could prepare a budget for the pending period to specifically provide for an increase in net worth by acquiring more assets and/or paying down debts. This is accomplished by planning and requires strict control of income and expenses. A second approach would be to forecast expected increases in the market value of certain assets—primarily investment and tangible property assets. If the market value of the assets increased as expected and liabilities remained constant or decreased, an increase in net worth would result. (Note: Decreases in net worth would result from the opposite strategies/occurrences.) Of course that is also the old fashion way, you inherit wealth. 2-5 What is an income and expense statement? What role does it serve in personal financial planning? The income and expense statement captures the result of financial activities that you hoped would increase your wealth summarized for a month or a year. In personal financial planning, the statement permits comparison of actual results to the budgeted values to help you evaluate your financial plan. 2-6 Explain what cash basis means in this statement: “An income and expense statement should be prepared on a cash basis.” How and where are credit purchases shown when statements are prepared on a cash basis? The cash basis only records income that is received in cash or expenses that are paid in cash during the period. It ignores any amount that you are due [receivables] or that you will have to pay in the future [liabilities]. Payments on liabilities should be divided into payment of interest and payments on principle, but both are listed as expenses on a cash statement. Obviously the cash statement does not give a complete picture of a person income or expenses, but since most individuals do not have receivables and their liabilities are managed with monthly payments, the cash statement gives good information for financial planning. 2-7 Distinguish between fixed and variable expenses, and give examples of each. Fixed expenses are contractual, predetermined expenses that are made each period, such as rent, mortgage and loan payments, or insurance premiums. Variable expenses change each period. These include food, utilities, charge card bills, and entertainment. 2-8 Is it possible to have a cash deficit on an income and expense statement? If so, how? Yes, a cash deficit appears on a cash basis income and expense statement whenever the period's expenses exceed income. Deficit spending is made possible by using up an asset, such as taking money out of savings, selling an asset such as an investment, or incurring more debt, such as charging a purchase on a credit card. 2-9 How can accurate records and control procedures be used to ensure the effectiveness of the personal financial planning process? Before you can set realistic goals, develop your financial plans, or effectively manage your money, you must take stock of your current financial situation. Without accurate records, you do not have the needed information to make your financial decisions. 2-10 Describe some of the areas or items you would consider when evaluating your balance sheet and income and expense statement. Cite several ratios that could help in this effort. Ratios are used to relate items from the financial statements. These ratios provide useful information for specific decisions. From the Balance sheet: Current Ratio: Current Assets divided by Current Liabilities, useful for short term credit decisions Solvency ratio: Total net worth divided by total assets; measures the degree of exposure to insolvency Liquidity ratio: Total liquid assets divided by total current debts; measures the ability to pay current debts. From the Income Statement: Savings ratio: Cash surplus divided by income after taxes, indicates the portion of income you chose to save Debt service ratio: Total monthly loan payments divided by Monthly gross (before tax) income, provides a measure of the ability to pay debts promptly Return on Equity: Cash Surplus (a measure of net income) divided by New Worth, provides a measure of how well you managed your wealth. 2-11 Describe the cash budget and its three parts. How does a budget deficit differ from a budget surplus? A cash budget is a summary of estimated cash income and cash expenses for a specific time period, typically a year. The three parts of the cash budget include: the income section where all expected income is listed; the expense section where expected expenses are listed by category; and the surplus or deficit section where the cash surplus or deficit is determined both on a month-by-month basis and on a cumulative basis throughout the year. A budget deficit occurs when the planned expenses for a period exceed the anticipated income in that same period. A budget surplus occurs when the income for the period exceeds its planned expenses. 2-12 The Gonzales family has prepared their annual cash budget for 2016. They have divided it into 12 monthly budgets. Although only 1 monthly budget balances, they have managed to balance the overall budget for the year. What remedies are available to the Gonzales family for meeting the monthly budget deficits? Monthly deficits may be handled by shifting expenses to a later month or income to an earlier month. If that is not possible, the Gonzales family may withdraw an amount from savings or borrow a short-term loan to get the months in balance. Another alternative is to increase income perhaps with a second job or move to a higher paying job. 2-13 Why is it important to analyze actual budget surpluses or deficits at the end of each month? By examining end-of-month budget balances, and the associated surpluses or deficits for all accounts, a person can initiate any required corrective actions to assure a balanced budget for the year. Surpluses are not problematic. Deficits normally require spending adjustments during subsequent months to bring the budget into balance by year end. 2-14 Why is it important to use time value of money concepts in setting personal financial goals? A dollar today and a dollar in the future will be able to purchase different amounts of goods and services, because if you have a dollar today, you can invest it and it will grow to more than a dollar in the future. At the same time, inflation works against the dollar, because rising prices erode its purchasing power. Time value of money concepts help us quantify these changes in dollar values so that we can plan the amount of money needed at certain points in time in order to fulfill our personal financial goals. 2-15 What is compounding? Explain the rule of 72. Interest is earned over a given period of time. When interest is compounded, this given period of time is broken into segments, such as months. Interest is then calculated one segment at a time, with the interest earned in one segment added back to become part of the principal for the next time segment. Thus, in compounding, your money earns interest on interest. The rule of 72 is a quick way to approximate how long it will take for an investment to double in value. Divide 72 by the percentage rate you are earning on your investment, and the answer will be approximately how many years it will take for your money to double. For example, if your investment is earning 8%, divide 72 by 8 to see that in approximately 9 years your money will double. 2-16 When might you use future value? Present value? Give specific examples. Future value calculations show how much an amount will grow over a given time period. Future value is used to evaluate investments and to determine how much to save each year to accumulate a given future amount, such as the down payment on a house or for a child's college education. Present value concepts, the value today of an amount that will be received in the future, help you calculate how much a future cash receipt will be worth today, analyze investments, and determine loan payments. Solutions to Critical Thinking Cases 2.1 The Becker’s Version of Financial Planning Terry and Evelyn Becker are a married couple in their mid-20s. Terry has a good start as an electrical engineer and Evelyn works as a sales representative. Since their marriage four years ago, Terry and Evelyn have been living comfortably. Their income has exceeded their expenses, and they have accumulated an enviable net worth. This includes $10,000 that they have built up in savings and investments. Because their income has always been more than enough for them to have the lifestyle they desire, the Beckers have done no financial planning. Evelyn has just learned that she’s two months pregnant. She’s concerned about how they’ll make ends meet if she quits work after their child is born. Each time she and Terry discuss the matter, he tells her not to worry because “we’ve always managed to pay our bills on time.” Evelyn can’t understand his attitude because her income will be completely eliminated. To convince Evelyn that there’s no need for concern, Terry points out that their expenses last year, but for the common stock purchase, were about equal to his take-home pay. With an anticipated promotion and an expected 10 percent pay raise, his income next year should exceed this amount. Terry also points out that they can reduce luxuries (trips, recreation, and entertainment) and can always draw down their savings or sell some of their stock if they get in a bind. When Evelyn asks about the long-run implications for their finances, Terry says there will be “no problems” because his boss has assured him that he has a bright future with the engineering firm. Terry also emphasizes that Evelyn can go back to work in a few years if necessary. Despite Terry’s arguments, Evelyn feels that they should carefully examine their financial condition in order to do some serious planning. She has gathered the following financial information for the year ending December 31, 2016: Critical Thinking Questions 1. Using this information and Worksheets 2.1 and 2.2, construct the Becker’s balance sheet and income and expense statement for the year ending December 31, 2016. 2. 2. Comment on the Becker’s financial condition regarding (a) solvency, (b) liquidity, (c) savings, and (d) ability to pay debts promptly. If the Becker’s continue to manage their finances as described, what do you expect the long-run consequences to be? Discuss. The level of income is substantially covering their loan payments, thus assuming continued income, their debts are secured. The Becker’s income is sufficient to build a better Balance Sheet in the future so that their net worth should continue to grow. This is a two wage earner family. If one loses their job, that lost income will soon create problems since their current balance sheet does not have the assets to maintain their net worth for the future without the continuing income. 3. Critically evaluate the Becker’s approach to financial planning. Point out any fallacies in Terry’s arguments, and be sure to mention (a) implications for the long term, as well as (b) the potential impact of inflation in general and specifically on their net worth. What procedures should they use to get their financial house in order? Be sure to discuss the role that long- and short-term financial plans and budgets might play. At this point, the key to their future is maintaining the two income family. Long term if both incomes continue, the Beckers will build their net worth. While inflation is a constant threat, the impact will be on their real property and large priced personal property. They have a car and a house, thus until those must be replaced, inflation will have less concerned to them. If inflation runs away, their jobs could be at risk and all bets are off for their future financial position. Preparing a budget will certainly help guide them to better understand where they are going to be at the end of the year. 2.2. Brooke Stauffer Learns to Budget Brooke Stauffer recently graduated from college and moved to Atlanta to take a job as a market research analyst. She was pleased to be financially independent and was sure that, with her $45,000 salary, she could cover her living expenses and have plenty of money left over to furnish her studio apartment and enjoy the wide variety of social and recreational activities available in Atlanta. She opened several department-store charge accounts and obtained a bank credit card. For a while, Brooke managed pretty well on her monthly take-home pay of $2,893, but by the end of 2016, she was having trouble fully paying all his credit card charges each month. Concerned that her spending had gotten out of control and that she was barely making it from paycheck to paycheck, she decided to list her expenses for the past calendar year and develop a budget. She hoped not only to reduce her credit card debt but also to begin a regular savings program. Brooke prepared the following summary of expenses for 2016:
Item Annual Expenditure
Rent $12,000
Auto insurance 1,855
Auto loan payments 3,840
Auto expenses (gas, repairs, and fees) 1,560
Clothing 3,200
Installment loan for stereo 540
Personal care 424
Phone 600
Cable TV 440
Gas and electricity 1,080
Medical care 120
Dentist 70
Groceries 2,500
Dining out 2,600
Furniture purchases 1,200
Recreation and entertainment 2,900
Other expenses 600
After reviewing his 2016 expenses, Brooke made the following assumptions about her expenses for 2017: 1. All expenses will remain at the same levels, with these exceptions: a. Auto insurance, auto expenses, gas and electricity, and groceries will increase 5 percent. b. Clothing purchases will decrease to $2,250. c. Phone and cable TV will increase $5 per month. d. Furniture purchases will decrease to $660, most of which is for a new television. e. She will take a one-week vacation to Colorado in July, at a cost of $2,100. 2. All expenses will be budgeted in equal monthly installments except for the vacation and these items: a. Auto insurance is paid in two installments due in June and December. b. She plans to replace the brakes on her car in February, at a cost of $220. c. Visits to the dentist will be made in March and September. 3. She will eliminate her bank credit card balance by making extra monthly payments of $75 during each of the first six months. 4. Regarding her income, Brooke has just received a small raise, so her take-home pay will be $3,200 per month. Critical Thinking Question 1. a. Prepare a preliminary cash budget for Brooke for the year ending December 31, 2016, using the format shown in Worksheet 2.3. b. Compare Brooke’s estimated expenses with his expected income and make recommendations that will help him balance her budget. 2. Make any necessary adjustments to Brooke’s estimated monthly expenses, and revise her annual cash budget for the year ending December 31, 2016, using Worksheet 2.3. 3. Analyze the budget and advise Brooke on her financial situation. Suggest some long-term, intermediate, and short-term financial goals for Brooke, and discuss some steps she can take to reach them. Case 2.2, Problem 1a
Income and Expense Statement
Name: Brooke Stauffer For the Year Ending December 31, 2016
Income 2016 2017
Salary Alex’s take-home pay of $2,893/mo in 2016 and $3,200/mo in 2017 . $ 34,716 $ 38,400
Other income
(I) Total Income $ 34,716 $ 38,400
Expenses
Housing Rent $12,000 $12,000
Repairs
Utilities Gas, electric, water 1,080 1,134
Phone 600 660
Cable TV and other 440 500
Food Groceries 2,500 2,625
Dining out 2,600 2,600
Transportation Auto loan payments 3,840 3,840
Auto related expenses 1,560 1,638
Other transportation expenses
Medical Health-related insurance
Doctor, dentist, hospital, medicines 190 190
Clothing Clothes, shoes, accessories 3,200 2,250
Insurance Homeowner's
Life
Auto 1,855 1,948
Taxes Income and social security
Property (if not included in mortgage)
Appliances, furniture & other major purchases Loan payments 540 540
Purchases and repairs 1,200 660
Personal care Laundry, cosmetics, hair care 424 424
Recreation & entertainment Vacations 2,100
Other recreation and entertainment 2,900 2,900
Other items Misc. 600 600
Credit card pmts: 6 mo.@$75/mo. 450 450
Other expenses
(II) Total Expenses $ 35,979 $ 37,059
CASH SURPLUS (OR DEFICIT) [(I) – (II)] $ (1,263) $ 1,341
Case 2.2, Problem 2—Worksheet 2.3 ANNUAL CASH BUDGET BY MONTH
Name(s) Brooke Stauffer
For the Year ending December 31, 2017
INCOME Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec. Total
Take-home pay 3,200 3,200 3,200 3,200 3,200 3,200 3,200 3,200 3,200 3,200 3,200 3,200 38,400
[1] Total Income 3,200 3,200 3,200 3,200 3,200 3,200 3,200 3,200 3,200 3,200 3,200 3,200 38,400
EXPENDITURES
Rent 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 12,000
Gas & electricity 94 94 94 94 94 94 95 95 95 95 95 95 1,134
Phone 55 55 55 55 55 55 55 55 55 55 55 55 660
Cable TV 41 41 41 41 42 42 42 42 42 42 42 42 500
Groceries 218 218 218 219 219 219 219 219 219 219 219 219 2,625
Dining out 216 216 216 216 217 217 217 217 217 217 217 217 2600
Auto loan payments 320 320 320 320 320 320 320 320 320 320 320 320 3,840
Car expenses 129 220 128 129 129 129 129 129 129 129 129 129 1,638
Medical care, dentist 10 10 45 10 10 10 10 10 45 10 10 10 190
Clothing 187 187 187 187 187 187 188 188 188 188 188 188 2,250
Auto insurance 0 0 0 0 0 974 0 0 0 0 0 974 1,948
Installment loan for stereo 45 45 45 45 45 45 45 45 45 45 45 45 540
Personal care 35 35 35 35 35 35 35 35 36 36 36 36 424
Vacation 0 0 0 0 0 0 2,100 0 0 0 0 0 2,100
Other recreation & entertainment 241 241 241 241 242 242 242 242 242 242 242 242 2,900
Appliance purchases 55 55 55 55 55 55 55 55 55 55 55 55 660
Miscellaneous expenses 50 50 50 50 50 50 50 50 50 50 50 50 600
Credit card payments 75 75 75 75 75 75 0 0 0 0 0 0 450
Roth IRA contributions
[2] Total Expenditures 2,771 2,862 2,805 2,772 2,775 3,749 4,802 2,702 2,738 2,703 2,703 3,677 37,059
MONTHLY CASH SURPLUSES (DEFICIT) [1-2] 429 338 395 428 425 (549) (1,602) 498 462 497 497 (477)
CUMULATIVE CASH SURPLUS (DEFICIT) 429 767 1,162 1,590 2,015 1,466 (136) 362 824 1,321 1,818 1,341 1,341
3. Analyze the budget and advise Brooke on her financial situation. Suggest some long-term, intermediate, and short-term financial goals for Brooke, and discuss some steps she can take to reach them. Hanging by a thread summarize Brooke’s current position. The income statement for the two years provide sufficient information to assess her current position. It would be a good exercise for the class to discuss what could be reduced. Most likely the dining out, vacation, and recreation expenses will be suggested. Perhaps she could start a saving account to accumulate funds for the vacation. If the money is not there, do not go. Having the monthly budget and the income statement gives Brooke the info she needs to modify her spending decisions. Of course, if income could be increased, but that is most likely out of her control. Thus, the focus should be on expenses. Terms Found in the Chapter
annuity A fixed sum of money that occurs annually.
assets Items that one owns.
balance sheet A financial statement that describes a person’s financial position at a given point in time.
budget A detailed financial report that looks forward, based on expected income and expenses.
budget control schedule A summary that shows how actual income and expenses compare with the various budget categories and where variances (surpluses or deficits) exist.
budget variance The difference between the budgeted and actual amount paid out or received.
cash basis A method of preparing financial statements in which only transactions involving actual cash receipts or actual cash outlays are recorded.
cash budget A budget that takes into account estimated monthly cash receipts and cash expenses for the coming year
cash deficit An excess amount of expenses over income, resulting in insufficient funds as well as in decreased net worth.
cash surplus An excess amount of income over expenses that results in increased net worth.
compounding When interest earned each year is left in an account and becomes part of the balance (or principal) on which interest is earned in subsequent years.
current (short-term) liability Any debt due within 1 year of the date of the balance sheet.
debt service ratio Total monthly loan payments divided by monthly gross (before-tax) income; provides a measure of the ability to pay debts promptly.
discounting The process of finding present value; the inverse of compounding to find future value.
equity The actual ownership interest in a specific asset or group of assets.
expenses Money spent on living costs and to pay taxes, purchase assets, or repay debt.
fair market value The actual value of an asset, or the price for which it can reasonably be expected to sell in the open market.
financial plans Describes financial goals and provides the action plans for their achievement
future value The value to which an amount today will grow if it earns a specific rate of interest over a given period.
fixed expenses Contractual, predetermined expenses involving equal payments each period.
income and expense statement A financial statement that measures financial performance over time.
income Earnings received as wages, salaries, bonuses, commissions, interest and dividends, or proceeds from the sale of assets.
insolvency The financial state in which net worth is less than zero.
investments Assets such as stocks, bonds, mutual funds, and real estate that are acquired in order to earn a return rather than provide a service.
liabilities Debts such as credit card charges, loans, and mortgages.
liquid assets Assets that are held in the form of cash or that can readily be converted to cash with little or no loss in value.
liquidity ratio Total liquid assets divided by total current debts; measures the ability to pay current debts.
long-term liability Any debt due 1 year or more from the date of the balance sheet.
net worth An individual’s or family’s actual wealth; determined by subtracting total liabilities from total assets.
open account credit obligations Current liabilities that represent the balances outstanding against established credit lines.
personal financial statement Balance sheets and income and expense statements that serve as essential planning tools for developing and monitoring personal financial plans
present value The value today of an amount to be received in the future; it’s the amount that would have to be invested today at a given interest rate over a specified time period to accumulate the future amount.
personal property Tangible assets that are movable and used in everyday life.
real rate of return The rate of return earned after adjusting for the effect of inflation, also referred to as the real interest rate
real property Tangible assets that are immovable: land and anything fixed to it, such as a house.
rule of 72 A useful formula for estimating about how long it will take to double a sum at a given interest rate.
savings ratio Cash surplus divided by net income (after tax);indicates relative amount of cash surplus achieved during a given period.
solvency ratio Total net worth divided by total assets; measures the degree of exposure to insolvency.
timeline A graphical presentation of cash flows.
time value of money The concept that a dollar today is worth more than a dollar received in the future.
variable expenses Expenses involving payment amounts that change from one time period to the next.
. Chapter Outline Learning Goals I. Mapping Out Your Financial Future A. The Role of Financial Statements in Financial Planning B. Interlocking Network of Financial Plans and Statements II. The Balance Sheet: How Much Are You Worth Today? A. Assets: The Things You Own B. Liabilities: The Money You Owe C. Net Worth: A Measure of Your Financial Worth D. Balance Sheet Format and Preparation E. A Balance Sheet for Jack and Lily Taylor III. The Income and Expense Statement: What We Earn and Where It Goes A. Income: Cash In B. Expenses: Cash Out C. Cash Surplus (or Deficit) D. Preparing the Income and Expense Statement E. An Income and Expense Statement for Jack and Lily Taylor IV. Using Your Personal Financial Statements A. Keeping Good Records B. Managing Your Financial Records C. Tracking Financial Progress: Ratio Analysis D. Balance Sheet Ratios E. Income and Expense Statement Ratios V. Cash In and Cash Out: Preparing and Using Budgets A. The Budgeting Process B. Forecasting Income C. Forecasting Expenses D. Finalizing the Cash Budget E. Dealing with Deficits F. A Cash Budget for Jack and Lily Taylor E. Using Your Budgets VI. The Time Value of Money: Putting a Dollar Value on Financial Goals A. Future Value B. Future Value of a Single Amount C. Future Value of an Annuity D. Present Value 1. Present Value of a Single Amount 2. Present Value of an Annuity 3. Other Applications of Present Value VII. Inflation and Interest Rates A. Impact of inflation on financial plan B. Fisher equation Planning over a Lifetime Financial Impact of Personal Choices Financial Planning Exercises Solution Manual for Personal Finance Michael Joehnk , Randall Billingsley , Lawrence Gitman 9780357033609
