Chapter 2 personal finance
Chapter 2 personal finance FINC 2400 - 001
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This 14 page Class Notes was uploaded by Mary-Cynthia Okeke on Wednesday September 7, 2016. The Class Notes belongs to FINC 2400 - 001 at Auburn University taught by Sven Nicolai Thommesen in Fall 2015. Since its upload, it has received 12 views. For similar materials see Personal Finance in Finance at Auburn University.
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Date Created: 09/07/16
Personal Finance Chapter 2 Notes Personal cash flows statement A personal cash flow statement measures your cash inflow and cash outflows. Comparing your cash inflows and outflows allows you monitor your spending and determine the amount of cash that you can allocate toward savings or other purposes. Cash Inflows: the main source of cash here is salary for working people but there can be other important sources of cash. Deposits in various types of savings accounts can generate income in the form of interest. Some stocks also generate quarterly dividend income. Cash Outflows: this represents all your expenses. Expenses could be large or small. It is not important to document every expenditure, but you should track how you spend most of your money. There are different ways you can track your expenditures such as checkbooks, debit and credit cards, Quicken (software program), etc. Creating a Personal Cash Flow Statement Example, Cynthia Spencer tried to limit her spending in college but never created a cash flow statement. Now that she has begun her career and is earning her salary, she wants to monitor her spending on a monthly basis. She then decides to create a cash flow statement for the previous month. Cynthia’s monthly cash Inflows: her present salary is about $4000 per month ($48,000 annually) before taxes. For budgeting purposes, she is also interested in her disposable income (income – taxes). About $680 goes to taxes. Disposable income: Monthly salary: $4000 Monthly taxes: $680 = $3320 Then Cynthia also considers other potential sources of cash inflows. She does not receive any dividend income from stocks or interest from any savings account. Cynthia’s monthly cash outflows: Cynthia then looks in her checkbook register to see how she spent her money last month. $625 for rent $45 for internet services $65 for electricity and water $50 for cellular expenses. $305 for groceries Next, Cynthia reviews several credit card bills to estimate her other typical expenses on a monthly basis: $95 for clothing $160 for car expenses $750 for recreation and entertainment. Her total cash outflows were $2195 last month. Cynthia’s Net Cash flows: monthly cash inflows and outflows can be compared by estimating Net cash flows. It is calculated by subtracting outflows – inflows. $3320 $2195 = $1125. Personal Cash Flow Statement for Cynthia Spencer Cash Inflows Last Month Disposable income $3320 Interest on deposits $0 Dividend payments $0 Total Cash Inflows $3320 Cash Outflows Last Month Rent $625 Internet services $45 Electricity and water $65 Cellular expenses $50 Groceries $305 Clothing $95 Car expenses $160 Recreation and entertainment $750 Total Cash Outflows $2195 Net Cash flows +$1125 Factors that affect Cash Flows To enhance your wealth, the obvious thing to do is to maximize your cash inflows and minimize your cash outflows. Factors affecting Cash Inflows The stage in your career path: cash inflows are relatively small for college students or people who are just starting a career. However, they tend to increase as you gain experience or progress in your career. Age also affects your cash inflows. Young people tend to have small cash inflows due to the small amount of work experience they have while older people have more cash inflows due to a lot of experience. There are lots of exceptions to this such as women putting their careers on hold for their family, individuals moving from lowdemand industries to highdemand industries, etc. Type of job Income also varies by job type. A job that requires specialized skills usually brings in more income than jobs that require skills that can be easily obtained. Income level is also affected by demand for jobs. Number of Income earners in your Household if you’re the sole incomeearner in your home, cash inflows would usually be less but if there are two, income tends to increase and it increases the cash inflows to your home or household. Factors Affecting Cash Outflows The size of the family: A person who has a family usually has more expenses than a person without dependents. The more family members, the greater the number of expenses. Age: As people grow older, they tend to spend a lot of money on expensive houses, jewelry, cars, etc. Personal Consumption Behavior: Most people’s consumption behavior is affected by their income. For instance, a couple working full time tend to spend more money. However, this varies quite a lot. Some consumers spend excessively to gain immediate satisfaction while some attempt to match their peers. Forecasting your Cash Flows The next step in the budgeting process is an extension of the personal cash flow statement. A budget can also be referred to a cash flow statement because it is based on forecasted cash flows for a period of time. Cynthia Spencer wanted to determine whether she will have sufficient cash inflows this month. She used the personal cash flow statement she developed from last month to make the forecast. However, the statement is adjusted for some anticipated expenses, Total health care expenses for $430 Car maintenance expenses for $500 Cash Inflows Actual amounts last Expected amounts month this month Disposable income $2500 $2500 Interest on deposits $0 $0 Dividend payments $0 $0 Total cash inflows $2500 $2500 Cash Outflows Actual amounts last Expected amounts month this month Rent 600 600 Internet 50 50 Electricity and water60 60 Cellular 60 60 Groceries 300 300 Health cares 130 (430) insurance and expenses Clothing 100 100 Car expenses 200 (500) Recreation 600 600 Total cash outflows 2100 2700 Net cash flows +400 200 Expected Net cash flows = expected cash inflows – expected cash outflows. = 2,500 – 2700 = 200. Anticipating Cash Shortage In a month with a lot of unexpected expenses, you may not have enough sufficient cash outflows. If the cash shortage is small, you would likely withdraw funds from your checking account to make up the difference. The budget warns you of such a problem well in advance so you can plan out how to fix the problem. In reality, however, unanticipated expenses can occur due to various unexpected events. Assessing the Accuracy of the Budget Periodically compare your actual cash flows over a recent period of the predicted cash flows in your budget to determine whether your predictions are on target. Many individuals tend to be too optimistic about their cash flow predictions. They overestimate their cash inflows and underestimate their cash outflows thereby, causing their net cash flows to be lower than expected. Detecting such predicting errors would them to take steps in improving their budgeting. Forecasting Net Cash Flows over Several Months To forecast your cash flows for several months ahead, you can follow the same process as for forecasting one month ahead. Whenever particular types of cash flows are expected to be normal, they can be forecasted from previous months when the levels were normal. However, adjustments can be made to any cash flows that could be expected to abnormal. Creating an Annual budget If you want to know how much money you may be able to save in the next year, you can extend your budget out for longer periods. The process is the same for creating a budget for a month. The only difference is you multiply your cash flows by 12 to get a full year. Improving the Budget As time flies, you should review your budget to determine whether you're progressing towards the financials goals you made for yourself. To increase your savings or reduce liabilities, you should identify the components within the budget that you can change to improve your budget over time. PERSONAL BALANCE SHEET The next step in the budgeting process is to create your personal balance sheet. The personal balance sheet is a summary of your assets, your liabilities, and your net worth. Assets The assets on your balance sheet can be classified into three categories; liquid assets, household assets, and investments. Liquid assets Liquid assets are financial assets that can be easily sold without a loss in value. They are useful especially for covering upcoming expenses. Examples of liquid assets are; cash, savings accounts, and checking accounts. Household assets These include items typically owned by a household such as cars, furniture, and home. These assets tend to make up a larger proportion of your total assets than the liquid assets. Sometimes establishing the exact market value of a house may be difficult but you can always use market values of similar houses to obtain a reasonable estimate. Investments Some common forms of investments include; bonds, stocks, and rental property. Bonds are certificates issued by borrowers (usually firms and government agencies). Stocks are certificates representing partial ownership of a company. There are various reasons why firms issue stocks; to purchase machinery, building or other facilities. Mutual funds These funds sell shares to individuals and invest the proceeds in an overall portfolio of investment instruments such as bonds or stocks. They are managed by portfolio managers who decide what securities to buy so that the individual investors don’t have to make the decisions themselves. The minimum investment usually varies depending on the kind of investment and is typical between $500$3000 Real Estate This includes holdings in rental properties and land. Liabilities Liabilities represent debt and are categorized into current and long term liabilities Current liabilities These are debt that you would pay off in the near future typically within a year. The most common example is credit card bill. Credit cards deserve serious attention when discussing the personal budget. People who suffer from “shopping therapy” (a situation where someone shops to receive immediate satisfaction, usually don excessively), use their credit cards to buy things they don’t need or can’t afford which increases their credit card bills. They tend to forget that their main focus is their credit card bills and this type of behavior usually results in a large accumulation of debt. Longterm liabilities These are debt that would be paid over a period beyond one year. Examples are student loans. This debt usually requires you to pay interest expense from time to time. Other examples are car loans and mortgage loans. Net Worth Net worth is the difference between what you own and what you owe. It is a measure of your wealth. Some people tend to assess their wealth by examining their assets and neglecting their net worth. And this might even encourage to buy more things as long as they get the credit. Creating a Personal Balance Sheet You should create a personal balance sheet to determine your net worth. Cynthia Spencer wants to determine her net worth by creating a personal balance sheet that identifies her assets and liabilities. Cynthia’s assets $500 in cash $3,200 in her checking account Furniture in her apartment that is worth $900 $4,000 worth of stocks. A car worth $1,300 Cynthia’s liabilities She owes $3,000 in credit card bills Cynthia’s net worth Total assets – total liabilities = 99003000 = $6,900. Cynthia’s balance sheet ASSETS Liquid Assets Cash $500 Checking account $3,200 Savings account $0 Total liquid assets $3,700 Household Assets Home $0 Car $1,300 Furniture $900 Total household assets $2,200 Investment Assets Stocks $4,000 Total investment assets $4,000 Total assets $9,900 Liabilities and Net worth Current Liabilities Credit card balance $3,000 Total current liabilities $3,000 Longterm Liabilities Mortgage $0 Car loan $0 Total liabilities $3,000 Net Worth $6,900 Changes in the Personal Balance Sheet If you earn a new income or salary and spend all of it on frivolities, your net worth may decline. As you invest in assets, your personal balance sheet will change. Your net worth will only grow if you increase the value of your assets. How Cash Flows affect the Personal Balance Sheet If you use net cash flows to invest in more assets, you increase the value of your assets which increases your net worth. You can also increase your net worth by using net cash flows to reduce your liabilities. Impact of the Economy on the Personal Balance Sheet Economic conditions can affect your cash flows and therefore affect your personal balance sheet. Favorable economic conditions can increase job opportunities and therefore your income. Unfavorable economic conditions reduce job opportunities and therefore your income. It also affects the value of your assets. Analysis of the Personal Balance Sheet Liquidity: you need to monitor your liquidity over time to ensure that you have sufficient funds when they are needed. It can be measured by the liquidity ratio and is calculated as Liquidity ratio = liquid assets/current liabilities High liquidity ratio indicates a higher degree of liquidity. If it is less than 1.0, that means that you do not have sufficient liquid assets to cover your upcoming payments. Debt level : you also need to monitor your debt level to ensure that it does not become so high that you are unable to cover your debt payments. Hence your debt level should be measured relative to your assets. DebttoAsset ratio= total liabilites/total assets. Savings rate: to determine the proportion of disposable income that you save, you can measure your savings over a particular period in comparison to your disposable income. Savings rate= savings during the period/disposable income during the period.
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