Chapter 3 Notes – Planning with
Personal Financial Statements
1. How to create your personal cash flow statement
What is a Personal Cash Flow Statement?
- Personal cash flow statement is a financial statement that measures a
person’s income and expenses.
- Disposable or after-tax income is your income minus applicable income
taxes and other payroll deductions such as CPP and EI.
- Savings: There are short-, medium- and long-term saving plans.
o Short – Creating an emergency savings account
o Medium – Saving money for large purchases, like a car, vacation,
engagement ring.
o Long – No impact on life today, but will in the future. Paying down
mortgage, saving for retirement.
2. Factors that Affect your Cash Flows
Factors affecting income include
- Stage in your career
o Early career stage or prime earning stage
- The type of job you have and how much it pays.
o This is based on the skill level you have and the demand for those
skills
- Number of income earners in your household.
Factor affecting expenses include:
- Size of family
- Age
- Personal consumption behaviour and how you spend your money.
o People may be more inclined to spend more of their money, while
others would prefer to save more of it for the future.
3. Creating a Budget
A budget is a cash flow statement that is based on forecasted cash flows for a
future time period.
Budgets are useful for anticipating either cash surpluses or cash deficiencies.
- Cash surpluses may be used to
o Build an emergency fund
o Invest in additional assets
o Make extra payments to reduce personal debt.
To assess the accuracy of your budget, you should:
- Compare your actual income and expenses to your forecasted income and
expenses.
- Limit your spending to stay within your budgeted expenses
- Increase your forecast of expenses to reflect reality
Forecasting Error – The difference between your expected and actual income and
expenses.
- Positive difference = actual income or expense level was less than
forecasted.
- Negative difference = actual income or expense level was more than
forecasted.
To improve your budget, you must either increase your income, reduce your
expenses, or both.
Alternative Budgeting Strategies
1. Envelope Method
a. Stick to a cash only budget for the expense categories that are hardest
to control like recreation, dining out, small day to day expenses)
b. The idea is to create a separate envelope for each category and place
the budgeted cash amount in each envelope.
2. Pay Yourself First Method
a. Automatic transfer of money from your chequing account to your
savings account.
b. This method removes net cash flows at the beginning of the budget
period.
Summary of the Budgeting Steps
1. Create a budget
2. Set aside positive net cash flows
3. Assess the accuracy of your budget
4. Create a budget forecast
5. Use additional income wisely
6. Create an annual budget
7. Improve your budget
8. Consider ways to increase positive net cash flows (increase income, decrease
expenses)
9. Consider the envelope method
[Link] the Pay Yourself First Method
4. How to Create your own Personal Balance Sheet
A personal balance sheet include your:
- Assets (what you own)
- Liabilities (what you owe)
- Net Worth (assets – liabilities)
Snapshot of your wealth at a specific point in time. Creating your own personal
balance sheet will allow you to determine your net worth.
Assets include:
- Liquid assets Cash, chequing accounts, savings accounts.
- Household assets Car, furniture, condo/house.
- Investments
o Stocks
o Bonds
o Mutual funds
o Real estate
Liabilities include:
- Current liabilities (within a year debts)
- Long term liabilities (longer than a year debts)
5. Financial Ratio Calculations
Liquidity
These ratios monitor your liquidity over time to ensure that you have sufficient
funds when they are need to pay current debts.
Current Ratio = Liquid Assets / Current Liabilities
High current ratio means a high rate of liquidity. A low current ratio means that you
do not have sufficient liquid assets to over current debts.
It is better to have a high current ratio because that implies that you can cover any
short-term expenses. A CR <1 means that you do not have sufficient funds to cover
upcoming payments.
Liquidity Ratio = Liquid Assets / Monthly Living Expenses
This ratio tells you how many months of living expenses you can cover with your
present level of liquid assets
It is better to have a high liquidity ratio because the ratio tells you have many
months of living expenses you can cover with your present level of liquid
assets. A liquidity ratio less than 1.0 means that you do not have sufficient funds to
cover the expenses of a single month
Debt Level
Monitors your debt level to ensure that it does not become so high that you are
unable to cover your debt payments.
A debt-to-asset ratio greater than 100.00 percent implies a negative net
worth and a potential for not being able to pay off a debt. If Peter loses his job, he
would not be able to pay off his debt.
Debt-to-Assets Ratio = [Total Liabilities / Total Assets] x 100
Savings Ratio
This ratio measure your savings over a particular period in comparison to your
disposable income.
Savings Ratio = Savings during the period / disposable income during the
period
The Ratios include:
- Liquidity Ratios
- Debt Level Ratios
- Savings Ratios