Chapter 3 - Money Management Strategy: Financial Statements and Budgeting

The Budgeting Process

- Assess Your Current Situation - Plan Your Financial Direction - Implement Your Budget - Evaluate Your Budget Program Assets or decreased debt are evidence of a better financial position. A regular assessment of your financial standing is one of the foundation elements of budgeting activities.

Liquid Assets

Cash and items of value that can easily be converted to cash.

Assets

Cash and other property with a monetary value.

Step 6 - Record Spending Amounts

Example: Budget Variance If a family budgets $380 a month for food and spends $363, this would result in a $17 budget surplus. However, if the family spent $406 on food during the month, a $26 budget deficit would exist.

Step 3 - Budget an Emergency Fund and Savings

Financial advisers suggest that an emergency fund representing three to six months of living expenses be established for use in period of unexpected financial difficulty.

Ratios for Evaluating Financial Progress

Financial ratios provide guidelines for measuring the changes in your financial situation. These relationships can indicate progress toward an improved financial position.

Variable Expenses

Flexible payments that change from month to month. Common examples of variable cash outflows are food, clothing, utilities (such as electricity, telephone, cable and internet), recreation, medical expenses, gifts and donations.

Investment Assets

Funds set aside for long-term financial needs.

Debt Ratio

Liabilities / Net Worth

Current Ratio

Liquid Assets / Current Liabilities

Liquidity Ratio

Liquid Assets / Monthly Expenses

Discretionary Income

Money left over after paying for housing, food and other necessities.

Characteristics of Successful Budgeting

Money management experts advise that a successful budget should be 1. Well Planned - A good budget takes time and effort to prepare. Planning a budget should involve everyone affected by it. Children can learn important money management lessons by helping to develop and use the family budget.

Debt-Payment Ratio

Monthly credit payments / Take-Home Pay

Fixed Expenses

Payments that do not vary from month to month. Rent or mortgage payments, installment loan payments, cable television service fees, and a monthly train ticket for commuting to work are examples of constant or fixed cash outflows.

Record Cash Outflows

Step 1 - For a set time period (such as a month), record your income from various sources, such as wages, salary, interest, or payments from the government. Step 2 - Develop categories and record cash payments for the time period covered by the cash flow statement. Step 3 - Subtract the total outflows from the total inflows. A positive number (surplus) represents the amount available for saving and investing. A negative number (deficit) represents the amount that must be taken out of savings or borrowed.

Cash Flow

The actual inflow and outflow of cash during a given time period.

Deficit

The amount by which actual spending exceeds planned spending.

Surplus

The amount by which actual spending is less than planned spending.

Determine Net Cash Flow

The difference between income and outflows can be either a positive (surplus) or a negative (deficit) cash flow.

Budget Variance

The difference between the amount budgeted and the actual amount received or spent.

Net Worth

The difference between total assets and total liabilities.

Step 4 - Budget Fixed Expenses

The following sources can help you plan your spending: - Your cash flow statement - Consumer expenditure data from the Bureau of Labor Statistics - Articles in magazines such as Kiplinger's Personal Finance Magazine and Money - Estimates of future income and expenses and anticipated changes in inflation rates

Insolvency

The inability to pay debts when they are due because liabilities far exceed the value of assets.

Budgeting for Skilled Money Management

The main purposes of a budget are to help you: - Live within your income - Spend your money wisely - Reach your financial goals - Prepare for financial emergencies - Develop wise financial management habits

Step 1 - Set Financial Goals

Future plans are an important dimension of your financial direction. Financial goals are plans for future activities that require you to plan your spending, saving, and investing. Financial goals should take a S-M-A-R-T approach with goals that are : Specific, Measurable, Action-Oriented, Realistic and Time-Based. Your personal financial statements and budgeting allow you to achieve your financial goals with: 1. Your balance sheet: reporting your current financial position - where you are now. 2. Your cash flow statement: telling you what you received and spent over the past month. 3. Your budget: planning spending and saving to achieve financial goals.

Real Estate

Includes a home, condominium, vacation property or other land that a person or family owns.

Income

Inflows of cash to an individual or a household.

Revise Your Goals and Budget Allocations

What should you cut first when a budget shortage occurs? This question doesn't have easy answers, and the answers will vary for different household situations. The most common overspending areas are entertainment and food, especially away-from-home meals. Purchasing less expensive brand items, buying quality used products, avoiding credit card purchases, and renting rather than buying are common budget adjustment techniques. When having to cut household budgets, reduced spending most often occurs for vacations, dining out, cleaning and lawn services, cable/internet service, and charitable donations. At this point in the budgeting process, you may also revise your financial goals. Are you making progress toward achieving your objectives?

Step 2 - Estimate Income

You should next estimate available money for a given time period.

Compute Net Worth

Your net worth is the difference between your total assets and your total liabilities. Assets - Liabilities = Net Worth Example: If a household has $193,000 of assets and liabilities of $88,000, the net worth would be $105,000 ($193,000 minus $88,000).

Determine Amounts Owed

1. Current Liabilities - These liabilities include such things as medical bills, tax payments, insurance premiums, cash loans, and charge accounts. 2. Long-Term Liabilities - Debts you do not have to pay in full until more than a year from now. Common long-term liabilities include auto loans, educational loans, and mortgages. A mortgage is an amount borrowed to buy a house or other real estate that will be repaid over a period of usually 15 years or more. Similarly, a home improvement loan may be repaid over the next 5-10 years.

Two major categories of cash outflow:

1. Fixed Expenses 2. Variable Expenses

What are the four asset categories?

1. Liquid Assets 2. Real Estate 3. Personal Possessions 4. Investment Assets

Creating a Personal Balance Sheet

1. Step 1 - Prepare a total of all items of value (assets). Include amounts in bank accounts, investments, and the cost (or estimated current value) of your possessions. 2. Step 2 - List and total the amounts owed to others (liabilities). This list will include current debts, charge account/credit card balances, and amounts due on loans and mortgages. 3. Step 3 - Subtract total liabilities from total assets to determine net worth. This amount indicates the current financial position of an individual or a household. Since investment assets usually fluctuate in value, the amounts listed should reflect their value at the time the balance sheet is prepared.

Balance Sheet

A financial statement that reports what an individual or a family owns and owes; also called a net worth statement.

Cash Flow Statement

A financial statement that summarizes cash receipts and payments for a given period.

Personal Possessions

A major portion of assets for most people. Included in this category are automobiles and other personal belonging. While these items have value, they may be difficult to convert to cash. You may decide to list your possessions on the balance sheet at their original cost. However, these values probably need to be revised over time, since a three-year-old television set, for example, is worth less now than when it was new. Thus, you may wish to list your possessions at their current value (also referred to as market value). This method takes into account the fact that such things as a home or rare jewelry may increase in value over time. You can estimate current value by looking at ads for the selling price of comparable automobiles, homes, or other possessions. Or you may use the services of an appraiser.

Budget

A specific plan for spending income.

Savings Ratio

Amount Saved Each Month / Gross Income

Liabilities

Amounts owed to others.

Opportunity Cost and Money Management

Daily decision making is a fact of life, and trade-offs are associated with each choice made. In terms of money management decisions, examples of trade-off situations, or opportunity costs, include the following: - Spending money on current living expenses reduces the amount you can use for saving and investing for long-term financial security. - Saving and investing for the future reduce the amount you can spend now. - Buying on credit results in payments later and reduces the amount of future income available for spending. - Using savings for purchases results in lost interest earnings and an inability to use savings for other purposes. - Comparison shopping can save you money and improve the quality of your purchases but uses up something of value you cannot replace: your time.

Money Management

Day-to-day financial activities necessary to manage current personal economic resources while working toward long-term financial security.

Long-Term Liabilities

Debts that are not required to be paid in full until more than a year from now.

Current Liabilities

Debts that must be paid within a short time, usually less than a year.

Take-Home Pay

Earnings after deductions for taxes and other items; also called disposable income.

Components of Money Management

Three major money management activities are interrelated. First, personal financial records and documents are the foundation of systematic resource use. These provide written evidence of business transactions, ownership of property, and legal matters. Next, personal financial statements enable you to measure and assess your financial position and progress. Finally, your spending plan, or budget, is the basis for effective money management.

The process for preparing a cash flow statement is:

Total cash received during the time period - Cash outflows during the time period = Cash surplus or deficit