FIN533_CHAPTER 2.pdf

# Personal financial statements and money management This section provides a foundational understanding of personal financial statements and effective money management techniques to achieve financial objectives. ## 1. Personal financial statements and money management Money management involves the daily financial activities essential for managing personal economic resources while working towards long-term financial security. These decisions are the core of financial planning and must align with individual needs, goals, and circumstances [3](#page=3). ### 1.1 Relationships among financial documents and money management activities Daily spending and saving decisions are central to financial planning. Effective money management requires coordinating these decisions with personal needs, goals, and situations [3](#page=3). #### 1.1.1 Opportunity cost and money management Every financial decision carries an opportunity cost, which is the value of the next best alternative forgone [4](#page=4). * Spending money on current living expenses reduces the amount available for saving and investing [4](#page=4). * Saving and investing for the future means less money is available for immediate spending [4](#page=4). * Purchasing on credit commits future income, limiting current and future financial flexibility [4](#page=4). * Using savings for purchases results in lost potential interest earnings and depletes the savings pool [4](#page=4). * While comparison shopping can save money, it requires a valuable time investment [4](#page=4). > **Tip:** Understanding opportunity cost helps in making more informed decisions about resource allocation, balancing present desires with future financial well-being. #### 1.1.2 Components of money management Effective money management encompasses three key interconnected components: * Creating and implementing a plan for spending and saving (budgeting) [5](#page=5). * Creating personal financial statements, including balance sheets and cash flow statements of income and outflow [5](#page=5). * Storing and maintaining personal financial records and documents [5](#page=5). ### 1.2 Personal financial statements Personal financial statements serve as crucial tools for measuring financial progress and understanding one's financial standing [11](#page=11). #### 1.2.1 Purpose of personal financial statements The primary purposes of personal financial statements include: * Reporting your current financial position by detailing the value of your assets and the extent of your liabilities [11](#page=11). * Measuring progress towards achieving financial goals [11](#page=11). * Maintaining organized information on your financial activities [11](#page=11). * Providing essential data for preparing tax forms or applying for credit [11](#page=11). #### 1.2.2 The balance sheet The balance sheet, also known as the Net Worth Statement or Statement of Financial Planning, provides a snapshot of your financial position at a specific point in time. Its preparation involves three steps [12](#page=12): ##### 1.2.2.1 Step 1: Listing items of value (Assets) Assets are defined as cash and other possessions of value that you own. These can be categorized as [12](#page=12): * **Liquid assets:** Assets that can be easily converted to cash, such as checking accounts, savings accounts, and money market accounts. * **Real estate:** Property such as a home, land, or other buildings owned. * **Personal possessions:** Valuables like vehicles, furniture, and electronics. * **Investment assets:** Assets held for growth or income, such as stocks, bonds, mutual funds, and retirement accounts. ##### 1.2.2.2 Step 2: Determining the amounts owed (Liabilities) Liabilities represent the amounts you owe to others. They are typically categorized as [13](#page=13): * **Current liabilities:** Debts that are due within one year, such as credit card balances, short-term loans, and medical bills. * **Long-term liabilities:** Debts that are due in more than one year, such as mortgages, student loans, and car loans. ##### 1.2.2.3 Step 3: Computing net worth Net worth is calculated by subtracting total liabilities from total assets. The fundamental formula is [13](#page=13): $$ \text{Assets} - \text{Liabilities} = \text{Net Worth} $$ This can be rearranged to: $$ \text{Assets} = \text{Net Worth} + \text{Liabilities} $$ Insolvency occurs when an individual is unable to pay their debts when they become due [13](#page=13). > **Example:** If a household has assets totaling 193,000 dollars and liabilities amounting to 88,000 dollars, their net worth would be calculated as: > $$ 193,000 \text{ dollars} - 88,000 \text{ dollars} = 105,000 \text{ dollars} $$ [14](#page=14). Ways to increase net worth include increasing savings, reducing spending, increasing the value of investments and possessions, and decreasing outstanding debts [15](#page=15). #### 1.2.3 The cash flow statement The cash flow statement, also known as the personal income and expenditure statement, tracks the actual inflow and outflow of cash over a specific period [16](#page=16). ##### 1.2.3.1 Process for preparing a cash flow statement The preparation of a cash flow statement involves three key steps [17](#page=17) [18](#page=18): * **Step 1: Record income:** This includes all sources of cash received, such as wages, salaries, commissions, self-employment income, investment income, gifts, grants, scholarships, educational loans, government payments (e.g., Social Security, unemployment benefits), pension and retirement income, alimony, and child support payments [18](#page=18). * **Step 2: Record cash outflows:** This involves tracking all expenses, which are categorized into: * **Fixed Expenses:** Costs that do not vary significantly from month to month (e.g., rent/mortgage payments, loan payments, insurance premiums). * **Variable Expenses:** Costs that fluctuate based on usage or preference (e.g., food, utilities, entertainment, clothing). * **Step 3: Determine net cash flows:** This is the difference between total income and total cash outflows for the period. The net cash flow can be either positive (income exceeds expenses) or negative (expenses exceed income) [19](#page=19). The cash flow statement forms the basis for developing and implementing a comprehensive spending, saving, and investment plan. It helps individuals understand where their money is going and to make adjustments for better financial management [19](#page=19) [28](#page=28). ### 1.3 Budgeting and achieving financial goals A budget is a spending, saving, and investment plan designed to help individuals achieve their financial goals. Budgets provide a framework for managing cash effectively [28](#page=28). > **Example:** Preparing a monthly budget involves forecasting income and expenses for the upcoming month. By comparing actual spending to budgeted amounts, individuals can identify variances and make necessary adjustments to stay on track with their financial objectives [38](#page=38). > **Tip:** Regularly monitoring your budget and comparing it against actual financial activities is crucial for effective money management. Identifying variances helps in understanding spending patterns and making informed adjustments [38](#page=38). Using savings effectively is directly tied to achieving financial goals, whether short-term (e.g., a down payment on a car) or long-term (e.g., retirement). Personal financial statements and budgets provide the necessary data to plan and track progress toward these goals [28](#page=28) [29](#page=29). Assignments related to these concepts include preparing a personal balance sheet, a cash flow statement for a past month, and a monthly budget, followed by monitoring the budget and analyzing variances [38](#page=38). --- # Designing a system for maintaining personal financial records Designing an effective system for maintaining personal financial records is crucial for managing daily affairs, planning for the future, and making informed financial decisions. This organized approach allows individuals to track their financial progress, complete tax obligations accurately, and understand their available resources [6](#page=6). ### 2.1 Benefits of an organized system of financial records An organized system of financial records provides several key benefits: * Facilitates the timely payment of bills and daily business affairs [6](#page=6). * Enables effective planning and measurement of financial progress [6](#page=6). * Simplifies the completion of required tax reports [6](#page=6). * Supports making informed and effective investment decisions [6](#page=6). * Helps determine available resources for both current and future spending needs [6](#page=6). ### 2.2 Types of financial records and their locations Different types of financial records are best stored in specific locations based on their importance, frequency of access, and the difficulty of replacement. #### 2.2.1 Records for the home file The home file is suitable for records that are frequently accessed or are important for daily financial management. These include: * **Personal and employment records**: Documents related to your personal life and work history [7](#page=7). * **Money management records**: Information pertaining to budgeting, spending, and cash flow [7](#page=7). * **Tax records**: Documents necessary for tax preparation and filing [7](#page=7). * **Financial services records**: Information from banks, credit unions, and other financial institutions [7](#page=7). * **Consumer purchase, auto, and credit records**: Receipts, warranties, loan documents, and credit card statements [7](#page=7). * **Housing records**: Documents related to property ownership, mortgages, and renovations [7](#page=7). * **Insurance records**: Policies and claims information for various types of insurance [7](#page=7). * **Investment records**: Details on stocks, bonds, mutual funds, and other investment holdings [7](#page=7). * **Estate planning and retirement records**: Documents related to wills, trusts, and retirement accounts [7](#page=7). #### 2.2.2 Records for the safe deposit box Records that are difficult to replace or are of critical long-term importance should be stored in a safe deposit box. These include: * Vital documents such as birth, marriage, and death certificates, and copies of wills [8](#page=8). * Citizenship and military papers [8](#page=8). * Adoption and custody papers [8](#page=8). * Serial numbers and photographs of valuable items for insurance purposes [8](#page=8). * Copies of certificates of deposit (CDs) and credit and banking account numbers [8](#page=8). * Mortgage papers and property titles [8](#page=8). * A list of insurance policy numbers [8](#page=8). * Stock and bond certificates [8](#page=8). * Valuable items like coins and other collectibles [8](#page=8). #### 2.2.3 Records for the personal computer A personal computer can be used to store and manage various financial records, especially digital or digitized documents. This includes: * Current and past budgets for financial planning [9](#page=9). * Summaries of checks written and other banking transactions for easy review [9](#page=9). * Past income tax returns, particularly those prepared using tax preparation software [9](#page=9). * Account summaries and performance results of investments to track their growth and returns [9](#page=9). * Computerized versions of wills, estate plans, and other important legal documents [9](#page=9). > **Tip:** Regularly back up important computer files to an external hard drive or cloud storage to prevent data loss. ### 2.3 Record retention periods The duration for which financial records should be kept varies depending on the type of document. * **Indefinite retention**: Birth certificates, wills, and Social Security information are vital documents that should be kept permanently [10](#page=10). * **As long as ownership exists**: Records pertaining to personal property and investments should be retained as long as you own those assets [10](#page=10). * **Indefinite retention for real estate**: Documents related to the purchase and sale of real estate, such as deeds and closing statements, should be kept permanently [10](#page=10). * **Six years**: Copies of tax returns and supporting documentation should be kept for a minimum of six years. This period generally covers the statute of limitations for most tax-related audits by tax authorities [10](#page=10). > **Example:** If you purchased a property for 200,000 dollars, you should keep all related documents indefinitely, even after selling it, as it might be relevant for future property transactions or tax implications. Similarly, if you bought stock for 1,000 dollars that is now worth 10,000 dollars, keep the purchase records as long as you own the stock. --- # Budgeting for skilled money management Budgeting is a fundamental aspect of skilled money management, acting as a proactive spending plan designed to guide financial decisions and achieve personal economic objectives [20](#page=20). ### 3.1 Purposes of a budget The primary goals of creating and implementing a budget are multifaceted, aiming to provide structure and control over one's financial life. These purposes include: * Living within one's income [20](#page=20). * Spending money wisely and purposefully [20](#page=20). * Achieving specific financial goals, such as saving for a down payment or retirement [20](#page=20). * Preparing for unexpected financial emergencies, thereby building financial resilience [20](#page=20). * Developing and reinforcing wise financial management habits for long-term success [20](#page=20). ### 3.2 The budgeting process The creation and implementation of a budget, often referred to as a spending plan or money plan, involves a systematic approach with distinct steps [21](#page=21). #### 3.2.1 Steps in the budgeting process The process of developing a budget typically includes the following sequential steps: 1. **Set financial goals:** Clearly define what you aim to achieve financially, whether short-term or long-term [22](#page=22). 2. **Estimate income from all sources:** Accurately determine all anticipated income, including salaries, wages, and any other revenue streams [22](#page=22). 3. **Budget for an emergency fund, periodic expenses, and financial goals:** Allocate funds specifically for building an emergency savings buffer, covering expenses that occur less frequently than monthly, and working towards your defined financial objectives [22](#page=22). 4. **Budget fixed expenses:** Account for all expenses that are obligated and generally remain the same each period, such as rent or mortgage payments [22](#page=22). 5. **Budget variable expenses:** Plan for household and living expenses where the amounts can fluctuate, such as groceries, utilities, and entertainment [23](#page=23). 6. **Record spending amounts:** Diligently track all actual inflows and outflows of money. This involves comparing the recorded spending with the budgeted amounts to identify any variances [23](#page=23). 7. **Review spending and saving patterns:** Regularly examine how money is being spent and saved to understand current habits [23](#page=23). 8. **Evaluate and revise:** Assess whether the current savings and spending plans need to be adjusted based on the review of patterns and variances [23](#page=23). ### 3.3 Characteristics of successful budgeting For a budget to be effective and sustainable, it should possess certain key characteristics: * **Well-planned:** It should be thoughtfully constructed with a clear understanding of income, expenses, and goals [24](#page=24). * **Realistic:** The budget must be achievable and align with actual income and spending capabilities [24](#page=24). * **Flexible:** It should allow for adjustments to accommodate unforeseen circumstances or changes in financial situations [24](#page=24). * **Clearly communicated:** If multiple individuals are involved (e.g., in a household), the budget should be understood and agreed upon by all parties [24](#page=24). > **Tip:** Flexibility is crucial; life is unpredictable, and a rigid budget that cannot adapt is likely to fail. ### 3.4 Selecting a budgeting system Various systems can be employed to create and maintain a budget, catering to different preferences and technological proficiencies: * **Mental budget:** This is an informal budget kept entirely in one's head, relying on memory and estimation [25](#page=25). * **Physical budget:** This method involves using tangible envelopes to allocate cash for specific expense categories, such as food, rent, or transportation [25](#page=25). * **Written budget:** This approach utilizes written records, commonly employing spreadsheets like Microsoft Excel or Google Sheets budget templates for organization [25](#page=25). * **Computerized budget:** Dedicated financial software, such as Quicken, can be used for comprehensive budget management [25](#page=25). * **Mobile apps:** Numerous smartphone applications are available, offering features for monthly budgeting and daily expense tracking [25](#page=25). > **Example:** A student might start with a mental budget to track daily spending but transition to a written budget using a spreadsheet as they begin to earn a more substantial income and incur more complex expenses. --- # Money management and achieving financial goals This topic explores the integral relationship between effective money management, dedicated savings activities, and the successful attainment of personal financial objectives, focusing on identifying goals and employing suitable savings techniques for long-term security and wealth accumulation [26](#page=26). ### 4.1 The importance of savings goals Setting aside money is crucial for various financial purposes, ranging from immediate needs to long-term aspirations [26](#page=26). #### 4.1.1 Short-term and emergency savings goals * **Irregular and unexpected expenses:** Savings provide a buffer for unforeseen costs that may arise unexpectedly [26](#page=26). * **Replacement of major purchases:** Funds can be accumulated for significant asset replacements, such as vehicles, or for a down payment on a home [26](#page=26). * **Discretionary spending:** Savings can facilitate the purchase of desired items like recreational equipment or funding for vacations [26](#page=26). #### 4.1.2 Long-term financial security and wealth building * **Future expenses:** Savings are essential for covering substantial future costs, including retirement planning or funding a child's education [26](#page=26). * **Income generation:** Interest earned on savings can contribute to paying for ongoing living expenses, effectively generating income [26](#page=26). ### 4.2 Selecting effective savings techniques Various methods can be employed to facilitate regular and consistent saving habits [27](#page=27). #### 4.2.1 Automated savings strategies * **Payroll deductions:** Arranging for a portion of income to be directly deducted from paychecks and deposited into savings accounts is an efficient method [27](#page=27). * **Automatic transfers:** Setting up automatic payments from checking accounts to savings accounts or mutual funds ensures regular contributions [27](#page=27). #### 4.2.2 Consistent saving practices * **Regular saving:** The fundamental principle is to save money on a consistent basis [27](#page=27). * **Small savings accumulation:** Even saving coins and making periodic deposits can contribute significantly over time [27](#page=27). * **Percentage-based saving:** Writing a cheque each payday for a specified percentage of income and depositing it into savings helps maintain a disciplined approach [27](#page=27). > **Tip:** Automating savings through payroll deductions or automatic transfers is a highly effective way to ensure consistent progress towards financial goals, as it removes the temptation to spend the money before it's saved [27](#page=27). > **Example:** To save for a down payment on a house, an individual might set a goal to save 10,000 dollars within five years. They could then implement an automatic transfer of 167 dollars per month from their checking to their savings account to achieve this. (Calculated as 10,000 dollars / 60 months) [27](#page=27). --- # Personal finance ratios for financial health assessment This section introduces various personal finance ratios used to measure financial health and assess the ability to meet financial obligations [30](#page=30). ### 5.1 Current ratio The current ratio is a measure of your ability to pay short-term obligations using your short-term assets. It is adapted from a business context but can be useful in personal budgeting and financial health assessments [30](#page=30). * **Formula:** $ \text{Current Ratio} = \frac{\text{Liquid Assets}}{\text{Current Liabilities}} $ [30](#page=30). * **Benchmark:** A good benchmark is a current ratio greater than or equal to $1.0$ [30](#page=30). * A ratio of $1.0$ means you have enough liquid assets to cover your short-term debts [30](#page=30). * A ratio below $1.0$ indicates you may struggle to meet immediate financial obligations without borrowing or selling assets [30](#page=30). * For stronger financial health, many advisors recommend aiming for a ratio of $1.5$ to $2.0$ [30](#page=30). ### 5.2 Liquid assets to take-home-pay ratio This ratio measures how many percent or months you can support your current lifestyle using only your liquid assets, without any new income. It is a key indicator of your financial resilience in case of emergencies like job loss or illness [31](#page=31). * **Formula:** $ \text{Liquid Assets to Take-Home-Pay Ratio} = \frac{\text{Liquid Assets}}{\text{Take-home-pay}} $ [31](#page=31). * Take-home-pay is defined as Gross Salary minus compulsory deductions. In Malaysia, compulsory deductions include EPF, SOCSO, EIS, and MTD [31](#page=31). * **Benchmark:** * In months: $3$ to $6$ months [32](#page=32). * In percentage: $25\%$ to $50\%$ [32](#page=32). > **Example:** > If Liquid Assets = 5,000 dollars and Take-home-pay = 48,000 dollars annually: > > * In months: $(\frac{5,000}{48,000}) \times 12 = 1.25$ months [32](#page=32). > * In percentage: $(\frac{5,000}{48,000}) \times 100\% = 10.42\%$ [32](#page=32). A ratio below the recommended benchmark (less than $3$ months or $25\%$) makes you financially vulnerable in emergencies, increases reliance on debt, and leads to higher financial stress. It can disrupt long-term goals, reduce flexibility to seize opportunities, and limit your ability to cope with unexpected expenses, ultimately weakening your overall financial stability [32](#page=32). ### 5.3 Debt ratio The debt ratio is a financial indicator that shows what portion of your total assets is financed by debt. It helps assess your overall financial leverage and risk level, indicating how much you owe compared to what you own [33](#page=33). * **Formula:** $ \text{Debt Ratio} = (\frac{\text{Total Assets}}{\text{Total Liabilities}}) \times 100\% $ [33](#page=33). * **Benchmark:** * Generally below $50\%$ is considered healthy, meaning less than $50\%$ of your assets are financed by debt [33](#page=33). * A ratio between $50\%$ and $60\%$ is acceptable but indicates moderate financial risk [33](#page=33). * A ratio above $60\%$ suggests high reliance on debt and greater financial vulnerability [33](#page=33). ### 5.4 Debt service coverage ratio (DSCR) The Debt Service Coverage Ratio in personal finance measures your ability to repay debt using your take-home pay. It compares your net annual income to your total annual debt instalment payments, showing whether your income can comfortably cover your debt obligations [34](#page=34). * **Definitions:** * Take-home pay: Your net income after tax and deductions for the entire year [34](#page=34). * Total annual instalment payments: Includes all required annual repayments on loans, such as mortgage, car loan, personal loan, student loan, etc. [34](#page=34). * **Formula:** $ \text{DSCR} = \frac{\text{Take-home-pay}}{\text{Total annual instalment payment}} $ [34](#page=34). * **Benchmark:** * The benchmark for DSCR in personal finance is $\geq 2.0$ [35](#page=35). * A ratio of $2.0$ means you earn twice the amount you need to cover your annual debt repayments, considered financially healthy [35](#page=35). * A DSCR below $1.0$ means your income isn't enough to cover your debt payments, which is a critical red flag [35](#page=35). * A good DSCR is $2.0$ or higher, meaning your annual take-home pay is at least double your yearly debt instalments [35](#page=35). * A ratio between $1.5$ and $2.0$ is acceptable [35](#page=35). * A ratio below $1.0$ signals that you may not have enough income to meet your debt obligations, putting you at financial risk [35](#page=35). ### 5.5 Savings ratio The Savings Ratio shows the percentage of your take-home pay that you manage to save. It reflects your ability to set aside income for future needs like emergencies, retirement, or major goals and is a key indicator of financial discipline [36](#page=36). * **Formula:** $ \text{Savings Ratio} = (\frac{\text{Savings}}{\text{Take-home-pay}}) \times 100\% $ [36](#page=36). * **Benchmark:** A healthy savings ratio should be at least $10\%$ to $20\%$ of your take-home pay [37](#page=37). * $10\%$: Minimum recommended to build basic financial security [37](#page=37). * $20\%$ or more: Ideal level to support long-term goals and wealth building [37](#page=37). * Below $10\%$: Indicates low savings and potential difficulty preparing for future needs [37](#page=37). --- ## Common mistakes to avoid - Review all topics thoroughly before exams - Pay attention to formulas and key definitions - Practice with examples provided in each section - Don't memorize without understanding the underlying concepts

| Term | Definition | |------|------------| | Personal financial statements | Reports that detail an individual's financial position, including assets, liabilities, income, and expenses, used for measuring progress toward financial goals and for tax or credit applications. | | Money management | The day-to-day financial activities required to manage personal economic resources effectively, aimed at achieving long-term financial security. | | Financial planning | The process of setting financial goals and developing strategies to achieve them, coordinating decisions with personal needs, goals, and situations. | | Opportunity cost | The value of the next best alternative that must be forgone to pursue a certain action, such as spending money on current expenses instead of saving or investing. | | Balance sheet | A statement of an individual's financial position at a specific point in time, listing assets, liabilities, and calculating net worth. Also known as a Net Worth Statement. | | Assets | All cash and other property of value that an individual owns, categorized into liquid assets, real estate, personal possessions, and investment assets. | | Liabilities | The amounts that an individual owes to others, categorized into current liabilities (due within one year) and long-term liabilities (due in over one year). | | Net worth | The difference between an individual's total assets and total liabilities; it represents the residual wealth an individual owns. Calculated as Assets – Liabilities. | | Insolvency | The inability to pay debts when they are due, indicating a negative net worth or insufficient liquid assets to cover immediate obligations. | | Cash flow statement | A personal income and expenditure statement that reports the actual inflow and outflow of cash over a given time period. | | Income | All monetary and non-monetary resources received by an individual, including wages, salaries, investment returns, gifts, and government payments. | | Cash outflows | All expenditures of cash made by an individual, categorized into fixed expenses and variable expenses. | | Fixed expenses | Costs that do not vary from month to month, such as rent, mortgage payments, or loan installments. | | Variable expenses | Flexible payments that can change from month to month, such as food, entertainment, or utility bills. | | Budget | A spending plan that helps individuals live within their income, spend money wisely, reach financial goals, and prepare for emergencies. | | Emergency fund | A sum of money set aside to cover unexpected expenses or financial emergencies, such as job loss or medical issues. | | Periodic expenses | Expenses that occur at regular but infrequent intervals, such as annual insurance premiums or property taxes. | | Variance | The difference between the budgeted amount for an item and the actual amount spent or received. | | Current Ratio | A personal finance ratio calculated as Liquid Assets / Current Liabilities, measuring the ability to pay short-term obligations with short-term assets. A benchmark of $\ge$1.0 is recommended. | | Liquid Assets | Assets that can be easily converted into cash with minimal loss of value, such as cash in checking or savings accounts. | | Take-home-pay | An individual's net income after all compulsory deductions, taxes, and contributions have been subtracted from gross salary. | | Debt Ratio | A financial indicator calculated as (Total Liabilities / Total Assets) x 100%, showing the proportion of total assets financed by debt. A benchmark below 50% is generally considered healthy. | | Debt Service Coverage Ratio (DSCR) | A ratio measuring the ability to repay debt using take-home pay, calculated as Take-home-pay / Total annual instalment payment. A benchmark of $\ge$2.0 is considered financially healthy. | | Savings Ratio | A ratio calculated as (Savings / Take-home-pay) x 100%, indicating the percentage of income saved. A benchmark of 10% to 20% or more is recommended. |