Chapter 2

Measuring Your Financial Health

and Making a Plan
 Using A Balance Sheet to Measure
Your Wealth
• Personal balance sheet: the financial mirror
• The financial equation: calculating net worth
or equity

Assets - Liabilities = Net Worth

 Your Assets: What You Own
• Monetary
• Investment
• Retirement plans
• Real estate
• Automobiles and other vehicles
• Personal property
• Other tangible and intangible assets
Monetary Assets:
• Cash or other assets that
can be easily converted
into cash
• These assets provide
necessary liquidity in case
of an emergency.
• Examples -- cash, current
accounts, savings
accounts
 Investment Assets:
• Assets that are invested
for the future
• These assets are used to
accumulate wealth to
satisfy a goal.
• Examples -- stocks, bonds,
mutual funds, cash value
life insurance
 Retirement Plans:
• Investments by you or
your employer to save for
retirement
• Long-term investments
that often carry a penalty
if used before a certain
age
 Real Estate:
• Tangible asset such as
land and a dwelling,
reported as fair market
value
• Represents most of your
savings, and normally
appreciates in value
• Examples -- primary
residence, vacation home,
and rental property
Automobiles and Other Vehicles:
• Tangible assets that
normally must be
inspected and licensed
• Reported as fair market
value, but normally
depreciate in value
• Examples -- cars, trucks,
motorcycles, and
recreational vehicles
 Personal Property:
• Tangible assets that
represent your lifestyle
• Reported as fair market
value, but normally
depreciate in value
• Examples -- furniture,
electronics, clothing,
jewelry
 Other Assets:
• Any other tangible or intangible asset that
may or may not be of value
• Examples -- business ownership, collections,
money owed you
 Your Liabilities: What You Owe
• Current liabilities are liabilities that must be
paid-off within the next year.
– examples -- credit cards and utility bills
• Long-term liabilities are liabilities that extend
beyond one year.
– examples -- home mortgage and auto loans
 Your Net Worth: A Measure of Your
Wealth
• Insolvency: do you owe more than you own?
• How age affects net worth guidelines
• Uses of a balance sheet
 Using an Income Statement to Trace
Your Money
• Personal income statement -- the financial
motion picture
• Cash basis: statement based entirely on actual
cash flows
Income: Where Your Money Comes
From
• Sources of income: salary,
commission, bonus,
interest, dividend, rent,
income from business etc
• Income is amount
earned, not necessarily
amount received.
 Expenditures: Where Your Money
Goes
• The two major expenditure categories: Fixed
expenses and Variable expense
• Fixed / Non-Discretionary Expenses : Expenses
you don’t directly control -- e.g., mortgage,
rent, cable TV etc
• Variable/ Discretionary Expenses: Expenses
you can control -- e.g., food, entertainment,
clothing
Where Does It Go, On Average?
• Taxes, Food, Housing,
Medical Care
• The more earned, the
more spent on
education and
entertainment.
Using Ratios: A Financial Thermometer
• Question 1: Do you have adequate liquidity to
meet emergencies?
• Question 2: Do you have the ability to meet
your debt obligations?
• Question 3: Are you saving as much as you
think you are?
 Question 1: Do You Have Adequate
Liquidity
• Ratios to determine whether or not you have
enough monetary assets (1) to pay for an
unexpected large expense or (2) to tide you
over during periods of reduced or eliminated
earnings.
– Current ratio
– Month’s living expenses covered ratio
 Current Ratio
• monetary assets
current liabilities

• This ratio shows you whether you have

enough liquid assets to cover expenses
currently due.
 Interpretation
• Ratio greater than 2
recommended
• Track the trend and if
going down --make
changes
 Month’s Living Expenses Covered
Ratio
• monetary assets
month’s living expenses

• This ratio tells you how many months living

expenses you can cover with your present
level of monetary assets.
Interpretation
• The rule of thumb: 3 to 6
months of expenses
• Factors that affect the
rule of thumb:
– Available credit cards or
home equity loans
– Potential for higher
earnings on less liquid
accounts
– Stability of income
• Track the trend and if
going down--make
changes
 Question 2: Can You Meet Your Debt
Obligations?
• Ratios to determine whether or not you can
meet current or long-term debt obligations:
– Debt ratio
– Long-term debt coverage ratio
 Debt Ratio
• total liabilities
total assets

• This ratio tells you whether you could payoff

all your liabilities if you liquidated all your
assets.
Interpretation
• Represents
percentage of assets
financed with
borrowing
• Track the trend; ratio
should go down with
age
 Long-term Debt Coverage Ratio
• total income available after living expenses
total long-term debt payment

• This ratio tells you how many times you could

make your debt payments with your current
income.
 Interpretation
• Ratio of 2.5 or greater
recommended
• Track the trend and if
going down -- make
changes
• Consider the inverse --the
percentage of take-home
pay needed to repay debt
 Question 3: Are You Saving As Much
As You Think?
• Ratio to determine whether you are saving as
much of your income as you think.
– Savings ratio
 Savings Ratio
• income available for savings
income available for living expenses

• This ratio tells you what proportion of your

after-tax income is being saved.
 Interpretation
• India saving rate
typically 30%
• Varies with stage of
the financial life cycle
and goals
 Record Keeping
• The three reasons for accurate record keeping
– Preparing taxes
– Tracking expenses
– Providing information for others to use in the
event of an emergency
 Record Keeping (cont’d)
• The two steps of record keeping
– Tracking your personal financial dealings
– Storing your financial records in an accessible
manner
 Ways to Track Expenditures
• Using checks and credit cards: Those
expenditures leave a paper trail
• Using cash: Record expenditures in a notebook or
ledger
• Generating a monthly income and expense
statement
• Using computer programs to track all financial
transactions
• Learning what and where to keep records
 Exercise 1
Mukesh bought a flat for 12 Lakhs, worth 20 Lakhs today. He
has no loan repayments i.e. EMIs due on his flat. He has FDs
worth Rs. 2 Lakhs and cash of 30,000 in his account, jointly
held with his wife. He has mutual funds worth 1.5 Lakhs and
stocks worth 1.5 Lakhs. Ritesh, an old colleague of his, has
taken a loan from him for Rs. 50,000, for which he pays him
10,000 every month. His wife, Geeta is fond of diamond
jewellery and owns up to 3 Lakhs of diamond jewels.

Mukesh bought a car for 4 Lakhs, 3 years ago. He has a tax

liability of Rs. 35k per year. He has no other outstanding bills
pending, except for telephone and electricity bills to the tune
of Rs. 5,000 .
A] What is his net worth?
B] What is his current ratio and debt ratio?
 Exercise 2
• Anil lives in a flat, which he purchased 10 years ago for Rs. 10
Lakhs. There is a loan outstanding for Rs. 3 Lakhs left. The
monthly EMIs, which Anil pays towards the loan, is Rs. 4000
pm. His wife has jewellery worth Rs. 2 Lakhs.He has a car,
which he purchased for 3 Lakhs, four years ago.

• He pays a monthly EMI of Rs. 2000 for his car loan. His life
insurance and pension funds cost him Rs. 4000 pm. He earns
Rs. 40000 pm. His car requires petrol worth Rs. 3000 pm. The
grocery bill adds up to Rs. 8000 pm. His wife, Mina likes to eat
out. They spend Rs. 2000 on entertainment every month. His
mobile bill and utilities come to Rs. 6000 pm. His credit card
bill is Rs. 2000 pm.Anil earns interest income up to Rs. 400
pm.He has no other source of income.
• Prepare his income and expense statement. Is
there a surplus or a deficit?
• State the discretionary and non-discretionary
expenses.
• What is the percentage of discretionary and
non-discretionary expenses to the income?