Financial Planning Overview

Objectives:

• Set well defined goals.

• Determine your current financial position.

• Prepare a budget.

• Use creative solutions to stay on budget.

• Select the right savings instrument for your goals.

Introduction

• Your financial health determines standard of living.

• Basic human needs include food, clothing, transportation, and shelter.

• Lifestyle choices include hobbies, travel, career, entertainment, vehicles and homes.

• Although shelter is a basic human need, our choice of a home is often a lifestyle choice.

• The ability to afford a preferred lifestyle is financial independence.

Record Keeping

Critical documents need to be stored safely. Examples of common financial records:

• Bank reconciliation records• birth certificates• social security cards• insurance documents and claim forms• tax records• credit agreements• retirement account statements• warranty information• titles and deeds

Set up a filing system for your documents so you can stay organized and easily find your documents when they are needed. There are three main types of filing systems:

• Home Files

• Electronic Files – use to store you electronic records.

• Safety Deposit Boxes

Records should generally be kept for two years.

• Keep a two year record of your bank and credit accounts.

• There are some exceptions to this rule.• Tax records need to be kept for seven years.• records like birth certificates and social

security cards need to be kept for life.• Titles and deeds are kept as long as you

own the property.• Dispose of old records safely.

Creating a Financial Plan

The financial planning process is broken into six steps:

1) Create a list of financial goals.

2) Analyze your current financial situation.

3) Create a budget.

4) Select appropriate savings vehicles.

5) Measure the performance of your plan.

6) Adjust the plan as necessary.

Step 1: Create a List of Financial Goals

• Approach the task of setting financial goals seriously.

• Start with general ideas and then work to make a specific plan to achieve the desire.

• Start by asking yourself what do you want and when do you want to achieve it?

• Make sure you set goals for the near future, the next stage of your life, and for the distant future.

Brainstorm

• Brainstorming is the process of generating ideas without censoring your thoughts.

• To brainstorm get a pad of paper and a pen and write down any thoughts that come to mind.

• Don’t censor your thoughts.

• Then go over your list of ideas and select the ones you would like to turn into goals.

Turn Desires into Measurable Goals

1) A goal is more specific than a wish.

2) It includes an action plan of how to obtain the desire.

3) A well-defined goal is:– Specific– Measurable– action orientated– realistic– Time focused

Example 2.1

Becky Shuet is a 21 year old college student from Enid, Oklahoma. She still lives at home with her single mother and she works part time at Mason’s Auto Parts. She started her financial plan in the spring semester of 2009. She plans to graduate with a B.A. in accounting in May of 2011. She set the following goals for herself:

Short Term Goals

1. Pay off my MasterCard balance of $256 in 3 months by paying $90 a month.

2. Pay Mom back the $500 I borrowed in 10 months by paying her $50 a month.

Mid-Term Goals 3. Accumulate $5,000 in my savings account by May of 2011. The money will

be used for moving expenses to get my own apartment after graduation. I will save for 26 months. I currently have $400 dollars in my account, so I need to save an additional $4,600. I need to save $177 a month.

4. Buy a home 2 years after I graduate. I will need to save $10,000 between 2011 and 2013 to pay for the down payment and closing cost. I plan to buy a small house for about $100,000. I will put 5% down. I will save $417/month from my salary from my first full time job after graduation.

Long Term Goals 5. I plan to retire at 65. I would like to stay in the Midwest where I hope to

someday own some acreage. When I begin working after college, I will take advantage of any company-sponsored pension plan or company match to a 401K. After I purchase a home in 2013, I will put the $417 a month in my Roth IRA. This will allow me to save the maximum current allowable amount in my Roth IRA.

Notice Becky’s short term goals are more specific than her long term goals. Since she is still a college student she doesn’t know what her future income or expenses will be. Still she set clear goals in the long term. Each year as she works toward her goals and revises them she will be able to become more specific with her long term goals. Even though her long term goals don’t set an exact amount for her 401K, she will be better prepared to make wise decisions when she first starts out on her own. Instead of spending the maximum amount she can afford on an apartment or buying a new car immediately, she will be thinking about her retirement and saving to buy a house. Her goals will help her avoid some of the common pitfalls of overspending in the first years of her career.

Example 2.2

Becky currently has a Roth IRA. She started with $2500 she had in a savings account when she graduated from high school. Since the stock market is currently so volatile she has $1500 in money market account and $1034 of it in a mutual fund. Her account pays 1.05% interest on the money market account and the mutual fund fluctuates with the stock market. Assume she can average 7% on the mutual fund for the next 4 years. How much will Becky’s Roth IRA be worth when she can afford to start making contributions to it again?

Becky’s future value of the $1500 in cash:

• PV = $1,500

• i = 1.05%

• n = 4 years

• PV(1 + i)n = FV

• $1,500(1 + .0105)4 = $1,564

Becky’s future value of $1,034 in mutual funds:

• PV = $1,034

• i = 7%

• n = 4 years

• $1,034(1 + .07)4 = $1,355.36

Becky’s future value of her Roth IRA = $1,564 + $1,355.36 = $2,919.36.

Now if Becky deposits $5,000 a year starting when she is 25 how much will she have in her Roth IRA when she is 60? Since Becky will have 35 years to save she will invest in mutual funds. Use the historical stock market return rate of 10% annually.

Solution: Becky will make monthly deposits of ($5,000/12) = $416.67She will make (35 years)(12 months) = 420 depositsShe will earn (10% annually)/(12 months) = 0.83% monthly i =

0.0083Using the equation for a FV of a series of deposits

If Becky’s monthly deposits of $416.67 for 35 years grows to be $1,565,705.69 what is her total Roth IRA balance at that time? Remember she had $2,919.36 when she starting making these additional deposits. Assume she decided to invest the whole$2,919.36 in mutual funds that earn a 10% return annually, when she begins making her additional deposits.

Solution:

• $2,919.36(1 + .10)35 = $82,041.13• Becky’s Roth IRA is worth $1,565,705.79 + $82,041.13 = $1,647,746.92

• If Becky decided the future values calculations weren’t worth the time to calculate, she would have multiplied the $416.67 by 420 deposits. She would have calculated a savings of $175,001.40. She then would have added her $2,534. She would have calculated her total Roth IRA balance as $177,535.40. That is a miscalculation of over 1.4 million dollars.

Step 2: Determine Your Current Financial Position

• Personal financial statements are the tools we will use to determine your current financial situation.

Personal Financial Statements

• A cash flow statement lists your income and expenses

• A balance sheet lists your assets and liabilities.

Balance Sheet

• The balance sheet lists your assets and liabilities on a specific date.

• Used to determine a person’s net worth.• Net worth = total assets minus total liabilities.• The date you write your balance sheet is the date listed on

the balance sheet.• The balance sheet is accurate on the day it is written.• Think of a balance sheet like a financial snapshot.• View the example balance sheets found on the web

component under the Resources > Sample Excel Sheets link.

• A balance sheet is broken into three main parts: assets, liabilities and net worth.

• assets at the top• liabilities in the middle

Cash Flow Statement

• The cash flow statement shows your income and expenses over a period of time, typically a month.

• You can write a cash flow statement for any period of time: a day, a week, a year, but a month is the most common time frame for a personal cash flow statement.

• At the top of the cash flow statement, it typically says “For the month ending,” followed by a date.

• The cash flow statement can be written for the month ending January 31st, which obviously means for January 1st – 31st.

• The cash flow statement can also be written for the month ending March 15th, which means it covers the period from February 16th to March 15th.

• View the example cash flow statements found on the web component under the Resources > Sample Excel Sheets link.

The cash flow statement is divided into two main categories:

1) income

2) expenses• Calculate your net cash flow by subtracting your

total monthly expenses from your total monthly income.

• Net cash flow = Income – expenses• A positive net income is the amount saved for

the month.• A negative net income indicates the amount of

increased debt for the month.

Income• Paycheck• interest on savings accounts• unemployment benefits• child support• alimony• Record your net income.• Net income is your gross income minus taxes

and other paycheck deductions.• Record what you receive.• The cash flow statement records actual amounts

received, not estimated amounts.

Expenses

• fixed expenses -- don’t change from month to month– Mortgage payments– car loan payments

• variable expenses -- vary in amount from month to month– Food expenditures

Step 3: Create a Budget

• In step 1 you determined where you want to go.

• In step 2 you found out where you are.

• In step 3 you will plan how to get there.

A budget is similar to a cash flow statement

• The two look alike, but they look in opposite directions.

• A cash flow statement is a look back at what you earned and spent last month.

• A budget is an estimate of what you will earn and spend next month.

To Create a Budget

• Start with last month’s cash flow statement and your written goals.

• Add a line item for each of your goals and record the dollar amount per month.

• If you have a goal of saving $50 a month to build an emergency fund, then add “Savings for emergency fund,” as a fixed expense.

• Once you add your goals, recalculate your net income.• If your net income is still positive or zero you can afford your

current goals.• If your net income is negative you need to readjust your goals

and/or your spending.• View Becky’s example balance sheets found on the web

component under the Resources > Sample Excel Sheets link.

Characteristics of a Good Budget

• Well-planned

• Practical

• Open to the family

• Flexible

Making a Budget Work

• Buy Used• Buy Staples• Make Gifts• Go Back to the Basics• Shop Off Season• Shop Thrift Stores and Garage Sales• Use Coupons• Buy Generics• Play Together

Step 4: Selecting the Right Savings Vehicle

• Savings Accounts• Money Market Accounts• CD’s Certificates of Deposit• IRA’s• Roth IRA’s• Money Market Funds• Mutual Funds• Bonds• Stocks

Step 5: Measure the Performance of the Plan

• Review your plan periodically, as is appropriate to how rapidly your finances change.– Quarter– six months– year.

• Update your balance sheet.• If you have been using your budget and comparing

your actual amounts to your budgeted amounts, your cash flow statement is already updated.

• Look at the new balance sheet. Check to see that your net worth is increasing.

Step 6: Make Changes and Adjustments to the Plan

• The purpose of reviewing your financial plan is to make adjustments.

• You may want to move money from one form of savings to another as you accrue higher account balances.

• If you paid off a debt last year, you will want to adjust your plan to re-allocate those funds.

Life and our personal circumstances are constantly changing.