Chapter 2

The Financial Plan

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 Learning Objectives

• Describe the purpose of a financial plan

• Identify the key components of a financial
plan

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 What is a Financial Plan?

• A personal financial plan involves specifying

financial goals including the spending, financing,
and investing plans needed to reach the goal
• A good financial plan is like a blueprint for a
builder.
• The plan should spell out every aspect of how to
accumulate and grow wealth and provide for
emergencies

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 What is a Financial Plan?

• A good financial plan includes 7 key components

(see figure 2.1):
– Budget and taxes
– Managing liquidity, or ready access to cash
– Financing large purchases
– Managing your risk
– Investing your money
– Planning for retirement and the transfer of your wealth
– Communication and record keeping

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 Figure 2.1

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 Check Your Financial IQ

• What is the purpose and function of a

financial plan?

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 Check Your Financial IQ

• It is like a blueprint to a builder. It spells out

every aspect of your financial life and helps
you accumulate wealth and plan for
emergencies

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 The Components of Your Financial
Plan

• The first step in building a financial plan is

understanding the different parts of it
• The following slides explore the seven
components and how they can help you
achieve financial security

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 Component One: A Plan for Your
Budgeting and Taxes

• Budgeting is the • A budget helps you plan your

process of spending and saving, so you can
forecasting meet your needs and wants.
future expenses • Creating a budget involves several
and income steps:
– Establishing your net worth
– Establishing your income
– Identifying your expenses
– Considering the impact of taxes

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 Step One: Establishing Your Net Worth

• The first step is to determine where you are

financially.
• Do you have money in the bank?
• Do you owe people money?
• Do you have a job?
• Knowing the answers to these questions will help
you determine your current financial positions.
• This will help you recognize how far you are from
your goals and help you set budget priorities

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 Step 1: Establishing Your Net Worth

• Assets are anything we • For example:

own, such as cars or
baseball cards. • Asset = Car worth = $5000
• Liabilities(debt) are
what we owe, or our
• Liability = Amount owed on
debt the car = -$2000
• Net Worth = Assets – • Net worth = Car value minus
Liabilities
• Equity means amount owed = $3,000
ownership • The equity would also be
$3000

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 Step 1: Establishing Your Net
Worth

• As you save money, you will accumulate more

assets (including cash)
• You will also have the chance to reduce your
liabilities
• Both of these will lead to increasing your net
worth
• Check out Figure 2.2 to see an example of
calculating net worth

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 Figure 2.2

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 Step 2: Establishing Your Income

• A key factor in shaping a budget is

• Income is the
understanding your income.
money coming in
through wages
• Having an income is the major means by
earned, allowance, which a person saves money, builds wealth,
or other sources acquires assets, and fulfills wants and needs.
• A person’s income often depends on
decisions he or she makes about education
and career choices.
• In general, more education or specialized
training translates into more income.

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 Math for Personal Finance
• Jamaal makes $9 an hour and works about 15 hours a week.
He also gets a $25 per week allowance. What is his total
annual income?

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 Math for Personal Finance

• Solution: $9 an hour x 15 hours per week =

$135 per week x 52 weeks per year = $7,020
per year income from his job. He also gets
$25 per week x 52 weeks per year = $1,300
per year income from his allowance. His
total annual income is equal to $7,020 +
$1,300 = $8,320

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 Step 3: Identifying Your Expenses

• Expenses are also an important part of a budget

• When creating a budget, estimate how much
money you have going out every month
• Typical expenses include clothing or
entertainment
• Refer to the chart in Figure 2.3 for typical
household expenditures

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 Figure 2.3

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 Step 4: Considering the Impact of Taxes

• Income taxes (money owed to the government

on earned income) may also impact your
budget
• The more money you make, the higher the
share of your income you will pay in income
taxes
• Include tax planning in your financial plan as
your income level increases

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 Component 2: A Plan to Manage Your
Liquidity

• Liquidity assets include cash and

• Liquidity refers to assets that can be quickly and
how much readily easily turned into cash
available cash you • Note that your liquidity is different
have on hand for than your net worth.
meeting immediate
wants and needs. • You may have a number of
valuable assets, but if they are not
liquid, they will be of little use to
you when facing a short-term
financial need.

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 Component 2: A Plan to Manage Your
Liquidity

• Money Management and Credit management decisions are

both involved in liquidity management.
• Money management involves making decisions about how
much cash or liquid assets to keep in reserve and how much to
invest in less liquid assets, such as real estate (buildings and
land).
• Money Management helps determine how much money to
keep liquid to avoid cash shortfalls.

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 Component 2: A Plan to Manage Your
Liquidity
• Credit Management involves making
• Interest is like decisions about getting credit and using
rent on money credit.
• Credit is commonly used to cover
immediate cash shortfalls, so it
increases liquidity.
• Credit can be very costly.
• When you use credit (borrow money)
the lender charges interest on the
money you borrow.

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 Component 2: A Plan to Manage Your
Liquidity

• Some lenders charge higher interest (rent) on

money than others.
• It is not wise to rely on credit cards if you are not
able to pay back the borrowed money quickly.
• A financial plan should contain a credit
management plan.
• Take a look at figure 2.4 for an illustration of
liquidity management.

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 Figure 2.4

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 Component 3: A Plan for Your
Financing

• Major purchases can require borrowing

money for long periods of time.
• It is common to pay for a portion of the cost
of these purchases and to take a loan for – or
finance – the remaining amount.
• Figure 2.5 illustrates this process

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 Figure 2.5

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 Component 3: A Plan for Your
Financing

• This type of borrowing (financing) differs

from the borrowing credit cards are often used
for.
• Longer-term financing is usually available at
a lower cost to the borrower than can be
found with credit cards
• Use of long-term financing requires great
caution

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 Component 3: A Plan for Your
Financing

• A number of factors determine how much you can

borrow and the payment terms.
• Payment terms include information about the interest
rate and the time period for paying back the loan
• You might be lent more money than you should
borrow.
• When you borrow money, you have a payment
schedule that requires you to make timely payments.

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 Math for Personal Finance
• Ruston plans on buying a car that is priced at $3,500. He
has saved $1,000 for a down payment and his grandparents
have agreed to contribute another $500 toward the purchase.
How much of the vehicle will Ruston need to finance?

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 Math for Personal Finance

• Solution: Ruston can put a total of $1,500

down on the car and finance the remainder
which is $3,50 - $1,500 = $2,000.

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 Component Four: A Plan to Manage
Your Risk

• Come up with a plan to protect assets as you

accumulate them.
• For example, if you buy a car, what happens if that
car is stolen or hit?
• Unless you have insurance on the car, you will suffer
the loss of that asset yourself.
• If there is a greater chance of you suffering a financial
loss, then the risk is higher.
• Many people purchase insurance

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 Component Four: A Plan to Manage
Your Risk

• Insurance planning is a component of your financial plan

• It determines the types and amounts of insurance you
need.
• People typically insure houses, boats, cars, and other
major assets.
• You also need insurance to cover you for unexpected
events, such as an illness or injury.
• Many adults have life insurance that will provide a cash
amount in the event of their death.

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 Component 5: A Plan for Your Investing

• Any funds you do not spend should be

invested with the expectation of earning even
more money.
• Common types of investments include:
– Stocks
– Bonds
– Mutual Funds
– Real Estate

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 Component 5: A Plan for Your Investing

• People invest money so they can make more

money
• Remember that different types of
investments have different levels of risk
• Riskier investments can produce great
returns—but also may experience significant
losses

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 Component 6: A Plan for Your
Retirement

• People who plan for retirement while they are

young often retire early
• Retirement planning involves determining how
much to save for retirement and how to invest that
money.
• The government provides several ways to save for
retirement that allow you to accumulate wealth
without paying taxes until you retire

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 Component 7: A Plan for
Communication and Record-Keeping

• Communicate your financial plan to your

family.
• Keeping good records of your finances is
equally important.
• These records will help you when you file your
taxes and calculate your net worth.
• Your heirs may also need these records at some
point as well.

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 Check Your Financial IQ
• What are the components of your financial plan?

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 Check Your Financial IQ

1. Budgeting and taxes

2. Managing liquidity, or ready access to cash
3. Financing large purchases
4. Managing your risk
5. Investing your money
6. Planning for retirement and the transfer of your
wealth
7. Communication and record keeping

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 Summary

• Financial planning involves specifying

financial goals
• It involves describing the spending,
financing, and investing plans needed to
reach those goals.
• Your plan is like a blueprint for your
financial future

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 Summary

• A good financial plan contains seven key components:

– 1. Budgeting and taxes
– 2. Managing liquidity, or ready access to cash
– 3. Financing large purchases
– 4. Managing your risk
– 5. Investing your money
– 6. Planning for retirement and the transfer of your
wealth
– 7. Communication and record keeping

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 Key Terms and Vocabulary

• Asset • Liquidity
• Budgeting • Money management
• Credit management • Net worth
• Equity • Payment terms
• Finance • Personal financial plan
• Income • Real estate
• Interest • Risk
• Liability

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 Websites

• www.bls.gov/news.release/cesan.nr0.htm
• Moneycentral.msn.com/home.asp

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