Maintaining financial records and planning your spending are essential
to successful personal financial management. The time and effort you devote
to these recordkeeping activities will yield benefits. Money management
refers to the day-to-day financial activities necessary to manage current
personal economic resources while working toward long-term financial
Much of that paperwork relates to financial matters. Invoices, credit
card statements, insurance policies, and tax records are the basis of
financial recordkeeping and personal economic choices.
An organized system of financial records provides a basis for
Handling daily business affairs, including payment of bills on time.
Planning and measuring financial progress. Completing required tax
reports.
PERSONAL FINANCIAL STATEMENTS FOR MEASURING FINANCIAL PROGRESS
The personal balance sheet and the cash flow statement provide information
about your current financial position and present a summary of your income
and spending. The main purposes of personal financial statements are to
Report your current financial position in relation to the value of the
items you own and the amounts you owe.
Measure your progress toward your financial goals.
Maintain information about your financial activities.
The Personal Balance Sheet: Where Are You Now? A balance sheet,
also known as a net worth statement or statement of financial position,
reports what you own and what you owe. A personal balance sheet is prepared
using the following process:
Step 1: Listing Items of Value. Available cash and money
in bank accounts combined with other items of value are the foundation of
your current financial position.
Assets are cash and other tangible property with a monetary value
and can be listed in four categories:
Liquid assets are cash and items of value that can easily be
converted to cash. Money in checking and savings accounts is liquid.
Real estate includes a home, a condominium, vacation property, or
other land.
Personal possessions are automobiles and other personal belongings.
While you may list these at their original cost; these values probably
need to be revised over time, listing your possessions at their current
value also referred to as market value.
Investment assets are funds set aside for long-term financial needs.
Step 2: Determining Amounts Owed.Liabilities
are amounts owed to others but do not include items not yet due, such as
next month's rent. Liabilities fall into two categories:
Current liabilities are debts you must pay within a short time,
usually less than a year, such as medical bills, tax payments, insurance
premiums, cash loans, and charge accounts.
Long-term liabilities are debts you do not have to pay in full
until more than a year from now and may include auto loans, educational
loans, and mortgages.
The debts listed in the liability section of a balance sheet represent
the amount owed at the moment; they do not include future interest payments.
Step 3: Computing Net Worth.Net worth is the
difference between your total assets and your total liabilities. This relationship
can be stated as Assets - Liabilities = Net worth
Net worth is the amount you would have if all assets were sold for the
listed values and all debts were paid in full. Also, total assets equal
total liabilities plus net worth.
The balance sheet of a business is commonly expressed as Assets = Liabilities - Net
worth
A person may have a high net worth but still have financial difficulties.
Having many assets with low liquidity means not having the cash available
to pay current expenses.
You can increase your net worth in various ways, including:
Increasing your savings.
Reducing spending.
Increasing the value of investments and other possessions.
Reducing the amounts you owe.
Remember, your net worth is not money available for use but an indication
of your financial position on a given date.
Evaluating Your Financial Position
A personal balance sheet helps you measure progress toward financial
goals.
Your financial situation improves if your net worth increases each time
you prepare a balance sheet. It will improve more rapidly if you are able
to set aside money each month for savings and investments.
Financial ratios provide guidelines for measuring changes in your financial
situation. These relationships can indicate progress toward an improved
financial position. Commonly used financial ratios include:
Debt ratio-liabilities divided by net worth-may be used to indicate
a person's financial situation; a low debt ratio is desired.
Current ratio-liquid assets divided by current liabilities-how well
a person will be able to pay upcoming debts.
Liquidity ratio-liquid assets divided by monthly expenses-indicates
the number of months that expenses can be paid if an emergency arises.
Debt-payment ratio-monthly credit payments divided by take-home pay-provides
an indication of how much of a person's earnings goes for debt payments
(excluding a home mortgage).
Savings ratio-amount saved each month divided by gross income-financial
experts recommend a savings rate of about 10 percent.
Each day, financial events can affect your net worth. When you receive
a paycheck or pay living expenses, your total assets and liabilities change.
Cash flow is the actual inflow and outflow of cash during a given
time period.
A cash flow statement, also called a personal income and expenditure
statement is a summary of cash receipts and payments for a given period,
such as a month or a year. This report provides data on your income and
spending patterns, which will be helpful when preparing a budget. A checking
account can provide information for your cash flow statement. Deposits
to the account are your inflows; checks written are your outflows. Of
course, in using this system, when you do not deposit the entire amounts
received, you must also note the spending of undeposited amounts in your
cash flow statement. 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
Step 1: Record Income. Income is the inflows of
cash for an individual or a household. For most people, the main source
of income is money received from a job. Other common income sources include
Wages, salaries, and commissions.
Self-employment business income.
Saving and investment income (interest, dividends, rent).
Gifts, grants, scholarships, and educational loans.
Government payments, such as Social Security, public assistance, and
unemployment benefits.
Amounts received from pension and retirement programs.
Alimony and child support payments.
Take-home pay is also called disposable income, the amount a
person or household has available to spend.
Discretionary income is money left over after paying for housing,
food, and other necessities. Studies report that discretionary income
ranges from less than 5 percent for people under age 25 to more than 40
percent for older people.
Step 2: Record Cash Outflows. Cash payments for
living expenses and other items make up the second component of a cash flow
statement. People commonly use two major categories:
Fixed expenses are payments that do not vary from month to month,
such as rent or mortgage payments, installment loan payments, cable television
service fees, and a monthly train ticket for commuting to work. Another
type of fixed expense is the amount a person sets aside each month for
payments due once or twice a year-such as auto or life insurance.
Variable expenses are flexible payments that change from month
to month. Common examples include food, clothing, utilities (such as electricity
and telephone), recreation, medical expenses, gifts, and donations. The
use of a checkbook or some other recordkeeping system is necessary for
an accurate total of cash outflows.
Step 3: Determine Net Cash Flow. The difference
between income and outflows can be either a positive (surplus) or a negative
(deficit) cash flow.
A deficit exists if more cash goes out than comes in during a
given month. This amount must be made up by withdrawals from savings or
by borrowing.
When you have a cash surplus, this amount is available for saving, investing,
or paying off debts. Or to set aside for an emergency fund or for unexpected
expenses.
Each day, you make many decisions that communicate your lifestyle
by indicating how you spend your time and money. The clothes you wear,
the food you eat, and the interests you pursue contribute to your lifestyle.
A person's lifestyle is influenced by three factors:
Career. Your job situation will influence the amount of income,
the way you spend your leisure time, and even the people with whom you
associate.
Family. The size of your household and the ages of its members
will also affect your lifestyle. The spending priorities of a couple
without children will differ from those of a couple with several youngsters.
Values. Ideas and beliefs you regard as important will strongly
influence your interests, activities, and purchasing habits.
Step 1: Setting 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.
Step 2: Estimating Income. First estimate available
money for a given time period. A common budgeting period is a month, since
many payments, such as rent or mortgage, utilities, and credit cards, are
due each month.
In determining available income, include only money that you are sure
you'll receive. Bonuses, gifts, or unexpected income should not be considered
until the money is actually received.
If you get paid once a month, planning is easy since you will work with
a single amount. But if you get paid weekly or twice a month, you will
need to plan how much of each paycheck will go for various expenses.
Step 3: Budgeting Emergency Fund and Savings. To set
aside money for unexpected expenses as well as future financial security,
you must budget amounts for savings and investments.
Financial advisers suggest that an emergency fund representing
three to six months of living expenses be established for use in periods
of unexpected financial difficulty.
Also set aside an amount each month for automobile insurance payment,
which is may be due every six months. Both this amount and the emergency
fund are put into a savings account that will earn interest.
A very common budgeting mistake is to save the amount you have left
at the end of the month. When you do that, you often have nothing left
for savings. Since savings are vital to long-term financial security,
advisers suggest that an amount be budgeted as a fixed expense.
Step 4: Budgeting Fixed Expenses. Definite obligations are
the basis for this portion of a budget. Fixed expenses include housing payments,
taxes, and loan payments.
Assigning amounts to spending categories requires careful consideration.
The amount you budget for various items will depend on your current needs
and plans for the future. The following sources can help you plan your
spending:
Your cash flow statement.
Consumer expenditure data for the Bureau of Labor Statistics at
stats.bls.gov.
Estimates of future income and expenses and anticipated changes in
inflation rates.
A detailed record of your spending is an important source for your spending
patterns. Use a simple system, such as a notebook or your checkbook. This
"spending diary" will help you know where your money is going.
Remember, a budget is an estimate for spending and saving intended to
help you make better use of your money, not to reduce your enjoyment of
life.
Step 5: Budgeting Variable Expenses. Planning for variable
expenses is not as easy as budgeting for savings or fixed expenses.
Variable expenses will fluctuate by household situation, time of year,
health, economic conditions, and a variety of other factors.
The rule of 72 can help you budget for price rises. At a 6 percent inflation
rate, prices will double in 12 years (72/6); at an 8 percent inflation
rate, prices will double in only 9 years (72/8).
Step 6: Recording Spending Amounts. After you have established
your spending plan, you will need to keep records of your actual income
and expenses similar to those you keep in preparing a cash flow statement.
A family's actual spending is not always the same as planned. A budget
variance is the difference between the amount budgeted and the actual
amount received or spent.
A budget deficit exists when actual spending exceeds planned
spending. A budget surplus occurs when actual spending is less
than planned spending.
Step 7: Reviewing Spending and Saving Patterns. Budgeting
is a circular, ongoing process. You need to review and revise your spending
plan on a regular basis.
The results of your budget may be obvious: having extra cash in checking,
falling behind in your bill payments, and or reduced use of credit.
Obvious results may not always be present. Occasionally, you will have
to sit down (with other household members) and review areas where spending
has been more or less than expected.
This review process is vital for both successful short-term money management
and long-term financial security.
What should you cut first when a budget shortage occurs? 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.
You may also revise your financial goals. Are you making progress toward
achieving your objectives? Have changes in personal or economic conditions
affected the desirability of certain goals? Have new goals surfaced that
should be given a higher priority than those that have been your major
concern?
Addressing these issues while creating an effective saving method will
help ensure accomplishment of your financial goals.
Characteristics of Successful Budgeting
Having a spending plan will not eliminate financial worries. A budget
will work only if you follow it. Money management experts advise that a
successful budget should be
Well planned. A good budget takes time and effort to prepare. Planning
a budget should involve everyone affected by it.
Realistic. A budget is designed not to prevent you from enjoying
life but to help you achieve what you want most.
Flexible. Unexpected expenses and changes in your life situation
will require a budget that you can easily revise.
Traditionally, the United States ranks fairly low among industrial nations
in savings rate. A low savings rate tends to slow economic growth with
fewer funds available for business borrowing and for creation of new jobs.
Low savings also affect the personal financial situations of people.
Studies reveal that the majority of Americans do not have an adequate
amount set aside for emergencies.
Since most people find saving difficult, financial advisers suggest
several methods:
write a check each payday and deposit it in a distant financial institution,
use payroll deduction,
save coins, or
spend less on certain items.
How you save is less important than making regular periodic savings
deposits that will help you achieve financial goals.
Small amounts of savings can grow faster than most people realize. For
example, at 5 percent interest, compounded daily, just $1 a day for 10
years will give you $4,700.
Calculating Savings Amounts
To achieve your financial objectives, you should convert your savings
goals into specific amounts. While certain saving methods involve keeping
money at home, those funds should be deposited in an interest-earning
savings plan on a regular basis.
To earn interest, you must learn to "hide" money, not in your
home but in an account at a financial institution or with an investment
company.
