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Chapter 2 personal finance

by: Mary-Cynthia Okeke

Chapter 2 personal finance FINC 2400 - 001

Marketplace > Auburn University > Finance > FINC 2400 - 001 > Chapter 2 personal finance
Mary-Cynthia Okeke

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these notes will cover what will be on the exam.
Personal Finance
Sven Nicolai Thommesen
Class Notes
Intro to Personal Finance
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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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