Finance lifestyle 3 stages, commences when you become financially independent
1) Early years (wealth accumulation)
2) Transition years (the “golden years”)
3) Retirement years (enjoying your savings)
Essence of financial planning
To ensure that you can meet the differences in earnings and expenditure through appropriate borrowing and saving.
The statements- Net-worth statement
1) Net worth statement is a snapshot of an individual / family’s assets/liabilities at a particular point in time
2) It is important for 2 reasons
- How we are progressing towards our goals (types of assets + net worth)
- Can be useful as a comparison point – e.g if saving for retirement compare with previous NWSs
- Also useful as it shows you what you have to manage (could be useful for insurance purposes)
Net worth statement- Who goes in?
1) May be straightforward if an individual or a couple with no children
2) May be extended family if appropriate (eg older children living at home or grandparents)
3) To some extent it will be defined for whom one is preparing the plan
4) Can be a bit blurred at the boundaries
Net worth statement- What do we include?
1) All assets, split into different categories (see handout) incl pensions.
2) Most important are the valuable ones and the ones that can be controlled / used for future planning.
Net worth statement- Liabilities
1) Could be split between current (eg domestic bills / taxes / credit cards
2) And long-term – mortgage / student loan / personal loan > 1 yr element)
Net worth statement- Valuation
1) Could be contentious in accounting
2) Value at MV for any financial asset (investment etc) – POSSIBLY NET OF TAX if material
3) Personal use assets = MV or replacement cost (eg clothes)
4) Value liabilities at the amount you owe
Income and Expenditure account
1) I&E shows us how we are moving towards our goals (summary of in- and outgoings)
2) Also provides basis for the budget – i.e. the plan for next year
3) Effectively a cash flow statement (no things like depreciation as with accounting)
4) Gross – obvious
5) Net = net of taxes deducted at source / pension contributions and so forth
Income and Expenditure contd
1) Could split expenses between discretionary and non-discretionary
- May be quite a bit of guesswork unless keep detailed records
- Might be worth doing this (eg for a 3 months and then extrapolate)
2) Note that the “annual surplus” is not what money has been saved, as will have put money towards pension, mortgage etc..
How to use financial statements- 3 ratios
There are three key concepts attached to this:
- Control
- Liquidity
- Planning
How to use financial statements- Control
- Benchmark to compare actual and planned spending
- Need to keep careful track of income and expenditure
- Liquidity =Ability to pay current liabilities
- Needs to be monitored to ensure that sufficient funds are available not to have to borrow money
How to use financial statements- Planning
- Budget may focus on goals, both long and short-term
- E.g. funding next year’s holiday or in the long term retirement funding
- Helps to determine how much is needed to be saved to meet those goals
How to use financial statements- Liquidity
- Everyone may have a different method no right or wrong
- Needs monitoring e.g. could use envelope system or pay yourself first
- Envelope – money (or paper) in an actual envelope – once runs out no money left to spend
- Pay yourself first – take 10% out to save then rest is left to spend
- Can use debit / credit cards to help – but care!
Current Ratio
- Current ratio = monetary assets / current liabilities = useful for liquidity (ideally should be in excess of 2)
- Trend analysis very useful
- BUT – weakness is that it excludes long-term debt payments (e.g. mortgage)
Living expense ratio
- Living expenses covered ratio = monetary assets / annual living expenses/12.
- Rule of thumb cover 3-6 months (note set up long before credit cards became the norm).
- Useful to set up emergency fund for this – so don’t need to liquidate investments.
- NOTE – if you have sufficient credit / insurance -protection you can reduce emergency fund and have money invested at a much better rate!!
Debt ratio
Debt ratio = total debt/total assets
Shows what percentage of of asssets financed by debt
Should get lower as you get older
Long-term debt coverage ratio
- Long-term debt coverage ratio = income available for living expenses / total long-term debt payments
- Number of times you can manage debt with current income
- Should be more than 2.5 times – v. general rule
- These ratios answer the question ” do you have the money to meet your debt obligations”
Savings ratio
-Savings ratio = income available for savings & investments / income available for living expenses
Look at trends!
consumer credit is an important aspect of personal financial planning as it impacts on:
Our ability to achieve financial objectives
Cash budgeting
How to establish credit
A prospective lender will look at your creditworthiness, that is:
- Net worth
- Earnings
- Credit history
How do lenders assess creditworthiness?
Gross debt service ratio and total debt service ratio
Credit scoring and the credit file
Will depend on a case-buy-case basis but normal rules are;
1) GDS – not over 30%
= annual mortgage payments + prop taxes 9council tax + home insurance) / gross annual income
2) TDS – not over 40%
= as above + other debt payments / gross family income
Credit management cont; One of the most important questions to ask is: how much debt can I afford? This depends on a number of matters, but the first thing to consider is one’s debt capacity:
- Most useful tool for this is a budget
- Include liquidity and solvency issues
- Risk tolerance will also need to be considered
Credit management cont: It is therefore useful if you use those measures when budgeting for a loan
- Will give you an idea of how much you can borrow
- Another useful tip is to consider matching the loan term with the useful life of the asset to be purchased.
- Consider also: debt safety ratio = Total monthly consumer credit payments / monthly take-home pay
- Aim for 10 – 15%
4 common features of a credit card
- Annual fee
- Grace period
- Interest rate on unpaid balance
- Additional features (e.g. freebies)
- If you pay balance off regularly 3 is irrelevant and can be very high if 1 or 2 are favourable.
