Chapter 2 Review Personal Finance

What is a budget? What is the purpose of a budget? How can a budget help when you are anticipating cash shortages or a cash surplus?

A budget is a forecast of cash inflows and outflows. A budget is developed to determine whether your anticipated cash inflows are sufficient to meet your cash outflows. When a period's budget indicates a cash shortage, you can plan to either use savings or borrow needed cash for the period. When a period's budget indicates a cash surplus, you can determine the amount of excess cash that you will have available to invest in additional assets.

How are cash flows related to your life stage or age?

As you age and your career progresses your earnings will increase. Typically, cash inflows are lower for younger people just entering the workforce. As our careers mature, we tend to earn more money until retirement when our cash inflows tend to decline. Cash outflows tend to increase after we begin our careers and begin to acquire a home and raise a family. As we mature and approach retirement our cash outflows will often fall as we pay off mortgages and no longer pay for the expenses associated with raising families.

Heather purchased a new car for $18,000 three years ago and listed the new car as an asset with a value of $18,000 on her personal balance sheet. She was able to borrow the entire $18,000 to purchase the car and listed the car loan as a liability with a value of $18,000. She just made the last payment on the car loan, so the liability is no longer on her personal balance sheet. However, the asset value of the car is still listed as $18,000. What adjustments should Heather make to the value of her assets in order to make her personal balance sheet more accurate?

Asset values should always be market values so Heather needs to adjust the value of the car down to its current market value.

Describe the process of creating an annual budget.

Begin with a monthly budget and extend it out over the year. Once you have created the annual budget, adjust it to reflect anticipated large changes in your cash flows.

What are bonds? What are stocks? What are mutual funds? Describe how each of these provides a return on your investment.

Bonds are IOUs issued by borrowers to raise funds. They represent the debt of the issuer. You earn interest while you hold the bond for a specific period. Stocks represent partial ownership in a company. Your return from stocks comes either from dividends or from selling the stock for more than you paid for it. Mutual funds sell shares to individuals and invest the proceeds in an overall portfolio of investment instruments. They are professionally managed and require minimal investments. Return comes from an overall increase in the value of the portfolio.

How does your choice of career affect your cash flows?

Cash inflow varies widely depending on job type or career. Jobs that require specialized training or education tend to pay more. Many jobs, such as nursing, require licensure and are also in high demand which pushes wages higher.

Define cash inflows and cash outflows and identify some sources of each. How are net cash flows determined?

Cash inflows are monies coming in, usually from wages. Cash may also come from other sources like interest, dividends, or gifts. Cash outflows are monies paid out for expenses such as rent, groceries, or gasoline. Net cash flows = Cash inflows - Cash outflows

List your monthly cash outflows. Will everyone have similar cash outflows?

Everyone's cash outflows will differ depending on family status, family size, age, and personal consumption behavior. However, common outflows include housing expenses such as rent, mortgage payments, utility bills, and insurance. Other common outflows are car payments and groceries.

Justin's stock portfolio increased in value during the year, and the balance on his mortgage declined. What happened to his net worth over the course of the year?

Justin's net worth increased since his asset values increased and his liabilities decreased. Increases in asset values and decreases in liabilities will both increase net worth assuming no other changes.

What are liabilities? Define current liabilities and long-term liabilities.

Liabilities are debt (what you owe). Current liabilities are debt that you will pay off withina year. Long-term liabilities are debt that will take longer than a year to pay off.

Name three classifications of assets. Briefly define and give examples of each.

Liquid assets are financial assets that can be easily sold without a loss in value. Examples include cash, savings account, and checking account. Household assets include items normally owned bya household. Examples include a home, car, and furniture. Investments are financial assets held with the intent of receiving a return. Examples include stocks, bonds, mutual funds, and real estate.

How might people who do not create a budget deal with cash deficiencies? How can this affect their personal relationships?

People who do not establish a budget may just deal with cash deficiencies when they occur. They often rely on family members or friends when they run short of funds, which may ultimately destroy relationships in the long run.

Describe two ways real estate might provide a return on an investment.

Real estate may provide a return as rental property rented out to others or as land purchased in hopes that its value will increase over time.

How can peer pressure affect your cash outflows?

Some people spend money to keep up with their peer group. They may buy cars or a house that is similar to their peers even though they cannot afford it which in turn leads to financial problems.

What is the liquidity ratio? What does it indicate? How is the debt-to-asset ratio calculated? What does a high debt ratio indicate? How is your savings rate determined? What does it indicate?

The liquidity ratio measures your liquid assets against your current liabilities. It is an indication of the sufficiency of your funds over the short term. The debt-to-asset ratio divides your total liabilities by your total assets. A high debt ratio indicates an excessive amount of debt. Your savings rate is determined by dividing your savings during the period by your disposable income during the period. The savings rate indicates the proportion of disposable income that you save.

What is a personal balance sheet?

The personal balance sheet summarizes your assets (what you own), your liabilities (what you owe), and your net worth (assets minus liabilities).

What two personal financial statements are most important to personal financial planning?

The personal cash flow statement and the personal balance sheet.

Explain in logical terms why values of assets such as homes and stocks may decline during a weak economy. How does this change affect your net worth?

The values of assets decline during a weak economy because consumer demand is low under these conditions and this tends to result in lower prices. The demand for homes declines when demand is low, causing sellers of homes to reduce their prices in order to entice potential buyers. The value of stocks or other investments in corporations is low when the corporations have weak performance. Corporations tend to experience weaker performance in a weak economy because consumer demand for products is low, and their sales are lower. Falling asset values decrease your overall net worth assuming your liabilities do not change.

Jeremey wants to increase his net worth. What advice would you give him?

To increase your wealth, you maximize your cash flows by maximizing your cash inflows and/or minimizing the cash outflows. Jeremey can look for ways to increase his income by working overtime or getting a second job. Or, he can look for ways to reduce his cash outflows by cutting back on spending.

How are unexpected expenses and liquidity related?

Unexpected expenses should be budgeted for periodically. You should assume that you are likely to incur some unexpected expenses over the course of several months, such as health care expenses or car repairs. You will find that you typically have unexpected expenses every year. Knowing that fact, you should build an emergency reserve or rainy day fund that is liquid enough for you to cover your unexpected expenses.

Explain how credit card usage can affect your spending habits.

Using credit cards can create the illusion of zero cost and ultimately result in higher levels of spending.

How does student loan debt affect your cash flows while in college? How does student loan debt affect your cash flows after college?

When you borrow money it will be a cash inflow at that time. In most cases payments are deferred until six to nine months after you graduate or quit school. At that time repayment will begin which is a cash outflow.

How do you assess the accuracy of your budget? How can finding forecasting errors improve your budget?

You can assess the accuracy of your budget by comparing your actual cash inflows and outflows with your budgeted amounts. Finding forecasting errors can allow you to adjust your spending to stay within your budgeted outflows. Alternatively, you may choose not to adjust your spending but to make your budget more realistic.

Suppose you want to change your budget to increase your savings. What could you do?

You could try to identify components of the budget that you can change to provide more cash for savings. For example, you could either attempt to increase your income or to reduce one or more expenses.

What three financial characteristics can be monitored by analyzing your personal balance sheet?

You may monitor your level of liquidity (liquidity ratio = liquid assets/current liabilities), your debt level (debt-to-asset ratio = total liabilities/total assets), and your savings rate (savings rate = savings during the period/disposable income during the period).

When does your net worth increase? Will the purchase of additional assets always increase your net worth? Why or why not?

Your net worth increases when the value of your assets increases more than your liabilities increase. The purchase of additional assets will not always increase your net worth if you gave up other assets (e.g., cash) of equal value to acquire them or if you incurred a liability of equal value to acquire them.

How does a personal balance sheet help you track your net worth?

Your personal balance sheet lists the market value of the things you own (assets) and also your current debts (liabilities). Your assets minus your liabilities is equal to your net worth.