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					                                         Topic 2: Financial Checkup
                                    BUS 440 Personal Investment Management

Now that you have a better idea of the various aspects of financial planning and its relationship to investment
planning, we will take our first step towards making better personal investment decisions. First, you need to learn
how to evaluate your current financial position and perform a financial checkup. You will do this by evaluating your
own personal financial statements.

Your personal financial statements are primarily made up of a personal balance sheet and a personal income
statement. The compositions of your personal financial statements are very similar to the ones of a company’s
financial statements.

        A personal balance sheet is made up of three components: assets, liabilities, and net worth.
        A personal income statement is made up of two components: income and expenses.


1.   Personal balance sheet

Evaluating your personal balance sheet helps you determine your wealth. We know that the balance sheet is made up
of three components. What does each component represent?

     (a) Assets




     (b) Liabilities




     (c) Net worth




What is the relationship among the three components?




Let’s take a look at Sam’s personal balance sheet as presented below:

                       Assets                                              Liabilities & Net Worth
Cash on hand                               $20.00          Loan from Mike                               $50.00
Balance in the checking account            125.00          Balance on Visa card                         140.00
Clothing inventory                         350.00          Balance on Master card                       165.00
Textbooks & supplies                       280.00          Total liabilities
Stereo unit & CDs                          145.00          Net worth
Total assets                                               Total liabilities & net worth



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Keep in mind that the balance sheet represents a snap shot of your financial position. It can change on a daily basis
as different financial transactions (or activities) take place. Let’s take a closer look at each of the components of the
balance sheet.

    (a) Assets

    There are 3 different categories of assets: liquid assets (i.e. assets to satisfy your liquidity needs), lifestyle assets
    (i.e. assets that are part of your lifestyle), and investment assets (i.e. assets that can increase your net worth or
    provide income for current use or for retirement).

         (i) Liquid assets

             A liquid asset is cash or any other asset that can be converted into cash with a minimum amount of
             convenience and with no loss in market value. Can you provide some examples of liquid assets?




         (ii) Lifestyle (or use) assets

             A lifestyle (or use) asset is an asset that helps you achieve your desired quality of life. This is also
             known as a household asset. In other words, a household asset is an item that is normally owned by a
             household. What are some examples of lifestyle (i.e. use or household) assets?




             To determine the market value of a lifestyle asset, it is necessary to know how much money you would
             receive if you sold the asset today. How would you determine the market values of some of the
             lifestyle assets you have mentioned above?




         (iii) Investment assets

             The purpose of owning investment assets is to provide additional income or increase your “wealth”
             over time. There are a variety of investment assets you can own. What are some examples of
             investment assets?




             Why is your primary residence is listed as a lifestyle asset but a rental property is listed an investment
             asset?



         Of all your assets, which asset do you consider to be the most valuable?




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     (b) Liabilities

     Liabilities are considered to be your debt obligations, i.e. the amount of money that you owe. Just as in the case
     with assets, you can group liabilities into two categories: current liabilities (i.e. a debt that must be paid off in 1
     year or less) and long-term liabilities (i.e. debt that takes longer than a year to pay off).

         (i) Current liabilities

              What are some examples of current liabilities?




         (ii) Long-term liabilities

              What are some examples of long-term liabilities?




     (b) Net worth

     Net worth is defined as the difference between your total assets and your total liabilities. We know that if:

         (i) Value of total assets > Value of total liabilities 
         (ii) Value of total assets < Value of total liabilities 

     Since your net worth plays an important role in estimating your financial strength, it is important for you to
     understand how it can be changed over time. Can you identify two ways (or methods) in which your net worth
     can grow (or shrink)?

         (i) Method 1




         (ii) Method 2




2.   Personal income statement

Your personal income statement helps you keep track of your cash inflow (i.e. money coming to you in the form of
income) and cash outflow (i.e. money “leaving” you in the form of expense). Why do you think it is important to
keep a good record of your personal income statement?




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    (a) Income

    Can you provide some examples of potential sources of income?




There are many factors that can potentially affect the size of cash inflow (or income) of a household. What are some
of them?




    (b) Expenses

    Expenses are considered as cash outflows that will sustain your scale of living. They can be both large and
    small. However, we are going to classify expenses into two different categories: inflexible expenses and flexible
    expenses.

        (i) Inflexible expenses

             Inflexible expenses (also known as fixed expenses) are the types of cash outflows that you have very
             little control in the short run. Some of them are even perfectly inflexible, which means that they can
             never change in amount. These fixed expenses are usually because of contractual agreements that
             require you to pay a certain amount of money every period. Can you provide some examples of
             inflexible expenses?




        (ii) Flexible expenses

             Flexible expenses (i.e. variable expenses) are the types of cash outflows that you have some control in
             the short run. Can you provide some examples of flexible expenses?




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              Keep in mind that some of the flexible expenses are more predictable than others. Can you identify
              which of the examples you have listed before as more predictable and as less predictable?




     Just as in the case with income, there are also a number of factors that can influence the size of your expenses
     (i.e. cash outflows). What are some of them?




3.   Evaluating your financial position

Just as in the case with a company, it is essential that you analyze your personal financial statements to help shed
some light on how well (or bad) you have been “performing” financially. There are several aspects we want to focus
on:

     (a) Match or beat the inflation rate

     It is important to make sure that your income and net worth increases match (and preferably exceed) the rate of
     inflation in general. Failure to do so on a consistent basis will lead to erosion in your scale of living and a
     diminished real net worth. By the way, what is the meaning of “real” net worth as compared to “nominal” net
     worth?




     To determine how your income has “performed” relative to inflation, you need to first determine the growth rate
     of your income, which can be determined using the following formula:

                                            Current year's nominal income 
                                            Prior year's nominal income   1.0
                   %  in nominal income                                 
                                                                          

     You can easily modify the formula to determine the growth rate of your net worth. All you need to do is replace
     nominal income with nominal net worth.




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    (b) Maintain adequate liquidity

    As you have learned earlier, it is important to maintain adequate liquidity to ensure that you have sufficient
    funds when you need it (such as paying bills on time). There are two ratios that can help you determine if you
    are sufficiently liquid: the liquid assets to take-home pay ratio and the liquid assets to current liabilities ratio.

        (i) Liquid assets to take-home pay ratio (Emergency Fund)

             Most experts agree that it is important to keep 3 to 6 months of your take-home pay in liquid assets to
             serve as a buffer in case of an emergency, hence the term "emergency fund". You can calculate the
             ratio as follows:

                                                                       Liquid assets
                            Liquid assets to take-home pay ratio                    12
                                                                      Take-home pay

             It is important to remember to make appropriate adjustments if you have other sources of income. If
             you do, they should be included in the denominator (after adjusting for taxes).

        (ii) Liquid assets to current liabilities ratio (or liquidity ratio)

             It is also important that you keep adequate liquid assets to meet the payment of your current liabilities.
             The liquidity ratio is calculated as follows:

                                                  Liquid assets
                            Liquidity ratio 
                                                Current liabilities

             How big should your liquidity ratio be?




    (c) Avoid excessive debt

    Are you carrying too much debt? It is important for you to know if you are carrying excessive debt. How do you
    define excessive?




    We will look at two ratios that will help you evaluate if you are carrying the “appropriate” amount of debt: total
    liabilities to total assets ratio and debt service coverage ratio.

        (i) Total liabilities to total assets ratio (or debt ratio)

             If your total liabilities exceed your total assets, you are considered to be insolvent. However, you
             might still be liquid in the short run (i.e. able to pay your bills by converting some of your assets into
             liquid assets), but if the situation does not change you will ultimately not have enough assets to cover
             your bills.

             Many people will end up filing for bankruptcy in a situation like this. As a result, it is important for
             you to detect early warnings of impending troubles. The debt ratio, which is calculated as follows, will
             help you determine if you are going to run into debt problems in the future:


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                                          Totalliabilities
                           Debt ratio 
                                           Totalassets

             What should the number be? In general, it is best to keep the number below 0.5. Keep in mind that the
             debt ratio is dependent on the market value of your total assets. If the market prices of your total assets
             is not very volatile (i.e. relative stable), then the ratio can be kept higher. However, if the market prices
             of your total assets is very volatile (i.e. not very stable), then the ratio should be kept lower.

         (ii) Debt service coverage ratio

             In your own words, define debt service?




             The debt service coverage ratio is calculated as follows:

                                                               Take-home pay
                           Debt service coverage ratio 
                                                             Debt service charges

             A higher ratio means that you have greater debt-carrying capacity. In other words, you can carry more
             debt because you have a greater capacity to pay your debt. Once again, you need to include other major
             sources of income (if any) in the numerator. How do you interpret the meaning of the following debt
             service coverage ratio?

             Debt service coverage ratio = 1




             Debt service coverage ratio < 1




             What is a good debt service coverage ratio?

             It is generally considered that you should have a ratio of 3.0 or higher. This means that a large portion
             of your income is not committed to repaying existing debt, which indicates that you have the financial
             strength and flexibility in future budgeting.


4.   Lessons learned?

What are some of the lessons you have learned about evaluating your financial positions?

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