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14.3: The Financial Planning Process

  • Page ID
  • Learning Objectives

    1. Identify the three stages of the personal-finances planning process.
    2. Explain how to draw up a personal net-worth statement, a personal cash-flow statement, and a personal budget.

    We’ve divided the financial planning process into three steps:

    1. Evaluate your current financial status by creating a net worth statement and a cash flow analysis.
    2. Set short-term, intermediate-term, and long-term financial goals.
    3. Use a budget to plan your future cash inflows and outflows and to assess your financial performance by comparing budgeted figures with actual amounts.
  • Step 1: Evaluating Your Current Financial Situation

    Just how are you doing, financially speaking? You should ask yourself this question every now and then, and it should certainly be your starting point when you decide to initiate a more or less formal financial plan. The first step in addressing this question is collecting and analyzing the records of what you own and what you owe and then applying a few accounting terms to the results:

    • Your personal assets consist of what you own.
    • Your personal liabilities are what you owe—your obligations to various creditors, big and small.
  • Preparing Your Net-Worth Statement

    Your net worth (accounting term for your wealth) is the difference between your assets and your liabilities. Thus the formula for determining net worth is:

    Assets − Liabilities = Net worth

    If you own more than you owe, your net worth will be positive; if you owe more than you own, it will be negative. To find out whether your net worth is on the plus or minus side, you can prepare a personal net worth statement like the one in Figure 14.6 “Net Worth Statement”, which we’ve drawn up for a fictional student named Joe College. (Note that we’ve included lines for items that may be relevant to some people’s net worth statements but left them blank when they don’t apply to Joe.)

    Figure 14.6 Net Worth Statement


  • Assets

    Joe has two types of assets:

    • First are his monetary or liquid assets—his cash, the money in his checking accounts, and the value of any savings, CDs, and money market accounts. They’re called liquid because either they’re cash or they can readily be turned into cash.
    • Everything else is a tangible asset—something that Joe can use, as opposed to an investment. (We haven’t given Joe any investments—such financial assets as stocks, bonds, or mutual funds—because people usually purchase these instruments to meet such long-term goals as buying a house or sending a child to college.)

    Note that we’ve been careful to calculate Joe’s assets in terms of their fair market value—the price he could get by selling them at present, not the price he paid for them or the price that he could get at some future time.

  • Liabilities

    Joe’s net worth statement also divides his liabilities into two categories:

    • Anything that Joe owes on such items as his furniture and computer are current liabilities—debts that must be paid within one year. Much of this indebtedness no doubt ends up on Joe’s credit card balance, which is regarded as a current liability because he should pay it off within a year.
    • By contrast, his car payments and student-loan payments are noncurrent liabilities—debt payments that extend for a period of more than one year. Joe is in no position to buy a house, but for most people, their mortgage is their most significant noncurrent liability.

    Finally, note that Joe has positive net worth. At this point in the life of the average college student, positive net worth may be a little unusual. If you happen to have negative net worth right now, you’re technically insolvent, but remember that a major goal of getting a college degree is to enter the workforce with the best possible opportunity for generating enough wealth to reverse that situation.

  • Preparing Your Cash-Flow Statement

    Now that you know something about your financial status on a given date, you need to know more about it over a period of time. This is the function of a cash-flow or income statement, which shows where your money has come from and where it’s slated to go.

    Figure 14.7 “Cash-Flow Statement” is Joe College’s cash-flow statement. As you can see, Joe’s income (his cash inflows—money coming in) is derived from two sources: student loans and income from a part-time job. His expenditures (cash outflows—money going out) fall into several categories: housing, food, transportation, personal and health care, recreation/entertainment, education, insurance, savings, and other expenses. To find out Joe’s net cash flow, we subtract his expenditures from his income:

    $25,700 – $25,300 = $400

    Figure 14.7 Cash-Flow Statement


    Joe has been able to maintain a positive cash flow for the year ending August 31, 2012, but he’s cutting it close. Moreover, he’s in the black only because of the inflow from student loans—income that, as you’ll recall from his net worth statement, is also a noncurrent liability. We are, however, willing to give Joe the benefit of the doubt: Though he’s incurring the high costs of an education, he’s willing to commit himself to the debt (and, we’ll assume, to careful spending) because he regards education as an investment that will pay off in the future.

    Remember that when constructing a cash-flow statement, you must record only income and expenditures that pertain to a given period, whether it be a month, a semester, or (as in Joe’s case) a year. Remember, too, that you must figure both inflows and outflows on a cash basis: you record income only when you receive money, and you record expenditures only when you pay out money. When, for example, Joe used his credit card to purchase his computer, he didn’t actually pay out any money. Each monthly payment on his credit card balance, however, is an outflow that must be recorded on his cash-flow statement (according to the type of expense—say, recreation/entertainment, food, transportation, and so on).

    Your cash-flow statement, then, provides another perspective on your solvency: if you’re insolvent, it’s because you’re spending more than you’re earning. Ultimately, your net worth and cash-flow statements are most valuable when you use them together. While your net worth statement lets you know what you’re worth—how much wealth you have—your cash-flow statement lets you know precisely what effect your spending and saving habits are having on your wealth.