Quiz 2: Developing Your Financial Statements and Plans

Business

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Types of personal financial statements: There are two types of personal financial statements which help in developing and monitoring personal financial plans. These are as follows: 1. Balance sheets: The personal balance sheet is the detailed summary of short term and long term assets and liabilities held by the person during a specified period. 2. Income and expense statement: The income and expense statement is the detail of all the revenue expenditures and incomes made by person during the specified period. Budget is the type of financial report which looks forward. Budget is the statement of expected incomes and expenses during the specified period of time. Budget is prepared in advance however, the personal financial statements give the actual details of assets and liabilities and income and expenses made. Role of financial report: The personal financial statements play an important role in the following ways: • They help in planning the savings and acquisition of any property. • They help in developing and monitoring personal financial plans. • The financial reports show the expenses which can be minimized.

The L family, Persons RL and LL, are married and expecting a baby. While they both currently work, Person LL plans to quit her job when the baby arrives. The L family is currently living comfortably with two incomes, with income exceeding investments and $10,000 in savings and investments. Person LL is worried about their finances with the addition of a new baby and loss of a second income, but Person RL is not concerned. He believes that he will soon receive a 10% increase in pay, and that their discretionary spending can be reduced if necessary. Person LL wishes to examine the family's current financial situation, and plan for their coming life changes. To do so, she has gathered their financial information for the past year. 1. A balance sheet is used to show current financial position. It includes a person's assets and debts at a given point in time and shows net worth , which is the difference between total assets and total liabilities. • An asset is an item that is owned, whether it was purchased with cash or financed with debt. Assets can classified as liquid , meaning they are in the form of cash, or can be easily converted to cash. Investments are another form of asset, such as stocks and bonds. Finally, real and personal property are tangible assets such as a house or car. An easy way to tell the difference is that real property generally grows in value over time, while personal property will generally decline in value over time. • A liability is a debt, such as loans, credit card balances, and mortgages. Liabilities can classified as short-term , meaning they are due within 1 year, or long-term , meaning they are due in longer than 1 year. To create Persons RL and LL's balance sheet, classify their assets and liabilities as defined above in the form of Worksheet 2.1 shown in the textbook. img An income and expense statement shows financial position over time. It is used to track income and expenses for a set period of time, such as monthly or yearly. Generally, it summarizes money earned versus money spent. • Income is defined as money received like salaries and bonuses from jobs; interest and dividends from investments; and proceeds from the sale of assets. • Expenses are defined as money spent such as living expenses (housing, food, utilities); taxes; purchase of assets such as a car; and miscellaneous expenses for things like entertainment or personal care. To create Persons RL LL's income and expense statement, use the form of Worksheet 2.2 shown in the textbook and follow these steps: 1. Record all income from various sources. 2. Create relevant expense categories 3. Subtract total expense from total income to get the cash surplus (income is more than expense) or deficit (expense is more than income). img INCOME AND EXPENSE STATEMENT Name(s): Persons RL and LL For the Year Ended INCOME Wages and salaries Name: $76,000 Name: 42,000 Total Income (I) $118,000 EXPENSES Housing Rent/mortgage payment $11,028 Utilities Gas, electric, water 1,990 Phone 640 Cable TV and other 680 Food Groceries and dining out 5,902 Transportation Auto loan payments 2,150 Transportation expense 2,800 Medical Unreimbursed expenses 600 Clothing Clothing, shoes, accessories 2,300 Insurance Homeowner's 1,300 Auto 1,600 Taxes Income and social security 36,539 Recreation and entertainment Vacation to Europe 5,000 Other recreation and entertainment 4,000 Other items Credit card payments 2,210 Purchase of common stock 7,500 Addition to money market account 500 Total Expenses (II) $86,739 CASH SURPLUS (OR DEFICIT) [(I) - (II)] $31,261 Note : Yearly mortgage payments of $11,028 include $1,400 for property taxes. 2. (a)To evaluate the L family's balance sheet for solvency we can use the solvency ratio, which is total net worth divided by total assets. This ratio measures their degree of exposure to insolvency (or inability to meet debt payments). img The L family's solvency ratio is 30%. This means that they would be able to withstand a 32% decline in the market value of their assets before they would be insolvent. (b)To evaluate the L family's balance sheet for liquidity we can use the liquidity ratio , which is total liquid assets divided by total current debts. This ratio measures their ability to keep paying current debts with liquid assets, if a loss of income occurred. img Person TB's liquidity ratio is 133%. This means that she would be able to pay 133%, or all , of their current liabilities (due within one year) with their existing liquid assets and still have liquid assets left over. (c)To evaluate the L family's income and expense statement for savings we can use the savings ratio, which is total cash surplus divided by income after taxes. This ratio measures the amount of cash left over during a given period. img The L family's savings ratio is 39% , which means they were able to save about 39% of their after-tax earnings. This is above average when compared to other American families. However, if they would have to live off of only one income, they would not be able to save as much. (d)To evaluate the L family's income and expense statement for ability to pay debt promptly we can use the debt service ratio, which is total debt payments divided by gross income. In this case, it would include the mortgage, car loan, and credit card payments. This ratio measures their ability to meet with debt payments promptly. img The L family's debt service ratio is 13% , which mean monthly debt payments are only about 13% of their gross income. This is well below the recommended maximum ratio of 35%. The L family is able to pay meet their current total debt payments with relative ease. 3. When the L family's approach to financial planning is critically evaluated, it is clear to see that it is not sustainable on a long-term basis. If they no longer have a double income, they will not be able to save or invest at all. In fact, they will need to use their existing savings just to meet expenses. This will result in a decrease in net worth. There are several fallacies present in Person RL's arguments: • He does not recognize that the family's expenses will increase significantly with the addition of a new baby. • He also does not account for any inflation or cost of living increase. • While he anticipates a promotion and corresponding 10% increase in pay ( not guaranteed) that will not be enough to make up for the loss of the second income and any new expenses. As stated above, the long-term implications of Person RL's approach to financial planning for negative. The loss of a second income and increase in expenses will mean a decrease in the family's investments and savings, and ultimately their net worth. In order to ensure that this does not happen, the family must proactively plan to increase their income or reduce expenses. The L family should immediately reevaluate their financial situation with the above factors taken into account. Then, they should create a conservative budget. To do so, they need to review their expenses and determine what can be reduced in order to stay within their new, lower expected income. The family may also want to record their planned and unexpected income and expenses from now on in order to get a better idea of their financial situation. This should help the family develop realistic short- and long-term financial goals as well as specific objectives in order to reach their goals.

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