2

MONEY MANAGEMENT
STRATEGIES AND SKILLS
Putti ng Your Fi nanci al House i n Order
Starting Point
Go to www.wiley.com/college/bajtelsmit to assess your knowledge of money
management strategies and skills.
Determine where you need to concentrate your effort.
What Youll Learn in This Chapter
Document organization, storage, and safekeeping
How to use personal balance sheets
How to calculate personal financial ratios
After Studying This Chapter, Youll Be Able To
Develop a system for organizing and maintaining your financial records
Calculate your net worth by using a personal balance sheet
Summarize your current inflows and outflows of cash by using a personal
cash flow statement
Use personal financial ratios to evaluate your current financial position
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2.1 COLLECTING AND ORGANIZING YOUR FINANCIAL INFORMATION 23
INTRODUCTION
The skills taught in this chapter provide the foundation for successful money
management. Youll learn to organize and maintain your financial records and
how to use personal financial statements to see how youre doing financially.
Youll also learn how to calculate the financial ratios that determine your cred-
itworthiness and how much you are saving. These tools will help you on your
road to financial success.
2.1 Collecting and Organizing Your Financial Information
Although some people love to file and organize, most people do not. The older
you get, the more stuff you accumulate, and it doesnt take long for a small pile
of paperwork to grow to fill several file cabinets. The earlier you develop a sys-
tem for organizing your financial records, the easier it is to maintain order as
your life becomes more complex. The Personal Financial Planner that can be
found in the Appendix and online includes a worksheet to help you get started
organizing your records.
2.1.1 Why You Need to Save Bills and Documents
The first rule of organization is that there should be a particular purpose for
everything you save and file. Although this list is not exhaustive, some possible
reasons for keeping particular documents are
Paying bills.
Tracking your budget.
Preparing for tax reports.
Making investment decisions.
Making insurance or warranty claims.
Ensuring prompt access to essential records.
2.1.2 How Long You Should Save Documents
Of course, you need not keep all your documents forever. How long you should
save each item depends on what you will use it for. Documents necessary for
bill paying and budgeting have only short-term usefulness. Thus you need to
save receipts for ATM withdrawals and deposits and for cash or credit purchases
only until you receive a statement verifying that your account was correctly
charged. You should keep bills for utilities, car expenses, and other irregular
expenses that are not tax deductible for a full year so that you can accurately
report the costs in your budget and personal cash flow statements.
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24 MONEY MANAGEMENT STRATEGIES AND SKILLS
You should file any documents that support tax deductions with your tax
records. Although most Internal Revenue Service (IRS) audits occur within three
years of the filing of a return, they can also occur later, so its generally recom-
mended that you keep tax records for seven years to be safe. The IRS audits
about 1 out of every 174 returns, and most audits occur in the first year fol-
lowing filing. Audits in later years are usually the result of irregularities discov-
ered in auditing earlier returns.
2.1.3 Where You Should Keep Documents
You can keep your personal financial documents anywhere, as long as you can
easily access them when necessary. A system of file folders kept in a file cabinet
or box is effective for most people. Although computer filing is also a possibil-
ity, most bills still exist on paper, so even if you can use your computer for some
filing purposes, you still need to store paper copies as well.
You should keep important personal documents and valuables, particularly
those that are difficult to replacepassports, birth and marriage certificates,
Social Security cards, stock certificates, wills, and deedsin a safe deposit box
or fireproof lockbox. A safe deposit box is a secure private storage area (usually
a small locking drawer) maintained at a remote location, often at a financial insti-
tutions place of business. A lockbox, which is a fireproof keyed safe that you
keep in your home, is not as secure as a safe deposit box because its usually
movable, and any thieves that break into your house are likely to look for it
right away. The primary purpose of a lockbox is to prevent loss or damage to
the documents in the event of a fire.
If you use your home computer for managing your finances, you should
be sure to regularly back up the information on a disk and store that disk
in a separate location, such as a friends house, your place of employment,
or a safe deposit box. You need to ensure that your electronic records will
be safe in the event of theft, fire, electrical outage, or water damage. The best
way to do this is to back up your records immediately whenever you make
any major changes to the files, such as when you pay bills or revise your
budget.
1. Explain the difference between a lockbox and a safe deposit box.
2. List the types of information you should store.
S E L F - C H E C K
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2.2 USING PERSONAL FINANCIAL STATEMENTS 25
2.2 Using Personal Financial Statements
After youve collected and organized your financial information, you can use it
to begin evaluating your financial condition. Personal financial statements
summarize your financial information in a way that makes it easy to see where
you stand and to plan for where you want to be in the future. Just as compa-
nies make regular reports on their financial status to their shareholders, you
should make a financial report to yourself.
Others might request the information contained in your personal finan-
cial statements (e.g., financial companies considering your application for a
loan, organizations evaluating your qualifications for a scholarship, financial
advisors helping you with your personal financial plan). In this section, youll
learn how to develop a personal balance sheet to estimate your financial net
worth and a personal cash flow statement to evaluate your cash inflows and
outflows.
2.2.1 Preparing a Personal Balance Sheet
How much are you worth today? In other words, how wealthy are you? This
calculation is a good starting point for financial planning. A personal balance
sheet is a financial statement that details the value of everything you own and
subtracts what you owe to others to arrive at your net worth, or the amount of
wealth you would have left after paying all your outstanding debts. A personal
balance sheet shows your assets and debts:
Assets are the things you own. Assets include liquid assets (such as
cash), personal property, real estate, and investments.
Debts, or liabilities, are the amounts you owe. Debts include both
short-term obligations, such as unpaid bills and credit card debt, and
long-term debts, such as student loans, car loans, and home mortgages.
To prepare a personal balance sheet, you start by making a list of everything
you own, beginning with the most liquid assetscash and near-cash assets that
can easily be converted to cash without loss of valueand ending with the least
liquid. Checking and savings accounts are examples of liquid assets; your auto-
mobile and home are not liquid because it would take time to sell them, and
you would incur transaction costs such as advertising fees and commissions. If
you needed cash in a hurry, you would probably also have to discount the price
to make a quick sale.
The next step in constructing your personal balance sheet is to make a list
of your debts. As with your assets, you start with short-term debts, such as cur-
rently unpaid bills, and end with long-term debts, such as your student loans
and home mortgage.
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26 MONEY MANAGEMENT STRATEGIES AND SKILLS
FOR EXAMPLE
A Personal Balance Sheet
Danelle, a senior at a large university in the Midwest, is graduating with a
biology major. She says, Im also getting a teaching certificate so that I can
be a high school biology teacher. My parents helped out with my first two
years, but now Im supporting myself with a part-time job, financial aid, and
student loans. Although I think Im in pretty good financial shape, I know
I need to get better organized. My biggest problem is that Im so busy
with my schoolwork and job responsibilities, its sometimes hard to even
find the time to pay my bills. To be totally honest, I also have a tendency
to avoid financial matters because Ive never particularly liked math. One of
my financial downfalls is that I love to shop for clothes and cant resist a
good sale. So my credit card balances have increased. Im a little nervous
about how Ill be able to pay them off, especially since Ill have to start pay-
ing my student loan once I graduate.
This section walks through how to create a balance sheet that itemizes
Danelles assets and debts, as shown in Figure 2-1. You can create your own
personal balance sheet by using the worksheet provided in the Personal
Financial Planner.
2.2.2 Valuing Your Assets and Debts
How do you go about assigning a dollar value to each asset and debt? Your most
recent bank statements give you the value of your checking and savings accounts.
For other assets, you can try to estimate the market value, or the price you
could sell them for today.
The market value is not the same as what you paid for an asset. For exam-
ple, if you just bought a new car, you wont be able to sell it now for what you
paid for it. Similarly, the market value of your stereo system is much lower than
what you paid for the system, even if its practically new. In contrast, you might
own some assets that have much higher market values than what you paid for
them. A first-edition comic book that you paid $1 for 10 years ago may be worth
$100 today. Also, normally, real estate increases in value over time, so your home
probably has a higher market value now than when you purchased it.
For some of your assets, such as your car, there may be a corresponding
debt. If you have outstanding debt on your car, you enter the market value of
your vehicle on the asset side of your balance sheet and the loan balance on the
debt side. Notice that Danelle has entered $5,000 as the value of her car and
$3,000 as the remaining balance on her car loan. If you lease a car, your pay-
ment obligations are a debt, but you dont own the car, so you shouldnt include
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2.2 USING PERSONAL FINANCIAL STATEMENTS 27
Figure 2-1
Danelle Washingtons personal balance sheet.
Danelle Washingtons Personal Balance Sheet, December 31, 2004
Assets
Checking accounts $ 500
Savings accounts 1,000
Money market accounts
Cash value of life insurance
Total Liquid Assets $ 1,500
Home furnishings 1,200
Jewelry/art collectibles 500
Clothing/personal assets 3,000
Market value of automobiles 5,000
Total Personal Property $ 9,700
Market value of investments
(stocks, bonds, mutual funds)
Employer-sponsored retirement plan
Individual Retirement Accounts (IRAs)
Other retirement savings
College savings plan
Other savings or investments
Total Investment Assets
Market value of home
Market value of investment real estate
Total Real Property
TOTAL ASSETS $11,200
Debts
Rent or mortgage payment $ 500
Utillities and other bills 130
Credit card minimum payments 150
Total Current Bills $ 780
Credit card balances
1. Master Card 4,200
2. JCPenney 1,000
Personal Loans
Car loans 3,000
Alimony/child support owed
Taxes owed (above withholding)
Total Short-Term Debts $ 8,200
Student loans 18,000
Home mortgage balance
Home equity loan
Other real estate loans
Other investment loans and liabilities
Total Long-Term Debt $18,000
TOTAL DEBTS $26,980
Net Worth Assets Debts $15,780
List the values of your liquid
assets (Chapter 5), household
goods, and automobiles
(Chapter 8).
List the market value of
assets, investments, and real
property (Chapters 8, 1115).
List your short-term and long-
term debts (Chapter 68).
Calculate your net worth by
subtracting total debts from
total assets.
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28 MONEY MANAGEMENT STRATEGIES AND SKILLS
it as an asset. You can estimate the market value of your car by using a current
automotive blue book, available in book form at most bookstores and libraries
or online (e.g., www.edmunds.com). In some cases, your cars value may actually
be less than what you still owe in car payments.
Although real property, including homes and other real estate, is not very
liquid, it may be your largest investment. Real estate values are determined by
the values of comparable properties in the area, so if you just enter what you
paid for a property on your balance sheet, you will be understating your actual
wealth. If you dont know of a recent sale of a similar property, you can con-
sult a real estate professional to help determine the value of your home or
other real estate investment. In general, real estate values increase over time,
so you need to update this information regularly. Because Danelle is renting
an apartment with some friends from school, she doesnt own any assets in
this category.
An insurance policy is counted as an asset only if its a policy that accumu-
lates cash value over time. If you cancel an insurance policy that has a cash sur-
render value, the insurer returns that amount of money to you. Because this is
an available source of cash, you should count it as an asset. Homeowners, auto,
and health insurance (discussed in Chapters 8 and 9) dont accumulate cash
value, but some types of disability and life insurance policies (discussed in Chap-
ters 9 and 10, respectively) may have cash value. This value is determined by
the contract terms and is generally much smaller than the face value of the pol-
icy. In some cases, insurance policies also allow you to borrow against the cash
value. If you have borrowed from one or more of your policies, you need to include
the amount owed as a debt on your personal balance sheet. Danelle doesnt
have any cash value insurance.
2.2.3 Calculating Your Net Worth
After you enter all the required information on your personal balance sheet, you
can calculate your net worth by using the following equation:
Net worth Total assets Total debts
Notice in Figure 2-1 that Danelles net worth is negative $15,780. What does
this mean? If Danelle sold all her assets and used the money to repay her debts,
she would still owe $15,780. In contrast, if your net worth is positive, it repre-
sents how much you would have left over after paying everything. Your net
worth is thus a measure of your wealth.
There is no magic number that represents the ideal amount of net worth
because it depends on an individuals life cycle stage and personal goals. How-
ever, in general, the larger your net worth, the better off you are financially.
What if you have negative net worth like Danelle? If youre like most stu-
dents, youre in the accumulation phase of your life cycle. Youre developing
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2.2 USING PERSONAL FINANCIAL STATEMENTS 29
skills and abilities that will lead to greater income and wealth in the future.
You may have student loans and car loans but little in the way of financial
investments. This situation is not overly troubling at such an early stage of life.
However, if it continues indefinitely, it will eventually result in insolvency,
which is the inability to pay debts as they come due. Insolvency can lead to
bankruptcy.
Its not uncommon for an individuals net worth to decline due to an unex-
pected change in life circumstances, such as an extended illness, the death of a
spouse, or a divorce. One of the purposes of developing and evaluating personal
financial statements is to identify ways to improve your situation so that you can
be better prepared for such problems. As you proceed through the financial plan-
ning process, you should keep this in mind and conscientiously attempt to
reduce your debt and increase your assets over time.
2.2.4 Preparing a Personal Cash Flow Statement
Your net worth is highly related to your spending and saving behavior. If you
consistently spend more than you earn, youll end up financing the extra con-
sumption through borrowing. In contrast, if youre a regular saver, youll accu-
mulate more assets over time.
On average, Americans spend more than they earn and have very low
savings rates. Not surprisingly, average household debt continues to rise
over time. This problem has been exacerbated over the past few years, as
increasing home values and low mortgage rates have encouraged many home-
owners to access home equity lines of credit to pay for vacations and other
non-investment expenses. When this happens, total debt goes up, and net
worth declines, as you will see when you look at credit in more detail in
Chapters 5 and 6.
A personal cash flow statement is a financial statement used to evaluate
the relationship between your income and expenditures. Whereas your personal
balance sheet is like a snapshot of your finances at a certain point in time, your
personal cash flow statement shows inflows and outflows of cash over a period
of time, often one month or one year.
You use a personal cash flow statement to carefully itemize the amounts of
money that come into your household from various sources as well as all the
money that goes out over the same period of time. You can utilize a worksheet
such to record your cash inflows and outflows; for example, Figure 2-2 shows
Danelle Washingtons personal cash flow statement for 2004. A blank worksheet
is included in your Personal Financial Planner; an alternative is to use the work-
sheets provided with a personal finance software package, such as Microsoft Money
or Quicken.
When should you record cash flows? You prepare a cash flow statement on
a cash basis, which means you record cash flows when they are received or
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30 MONEY MANAGEMENT STRATEGIES AND SKILLS
Figure 2-2
Danelle Washingtons Personal Cash Flow Statement, 2004
Cash Inflows
January 1 to
December 31,
Monthly 2004
Salary/wage income (gross) $792 $9,500
Interest/dividend income
Other income (self employment)
Rental income (after expenses)
Cash from sale or assets
Student loans 500 6,000
Scholarships 108 1,300
Other income
Gifts 17 200
Total Cash Inflows $1,417 $17,000
Cash Outflows
January 1 to
December 31,
Monthly 2004
Income and payroll taxes $71 $852
Groceries 171 2,052
Housing
Mortgage or rent 300 3,600
Property tax & insurance
Maintenance/repairs
Utilities
Heating 40 480
Electric 25 300
Water and sewer
Cable/phone/satellite 15 180
Car loan payments 113 1,356
Car maintenance/gas 80 960
Credit card payments 125 1,500
Other loan payments
Other taxes
Insurance
Life
Health 42 504
Auto 67 804
Disability
Other insurance
Clothing 25 300
Gifts 30 360
Other consumables (TVs, etc.)
Child-care expenses
Sports-related expenses 13 156
Health club dues
Uninsured medical expenses 17 204
Education 333 3,996
Vacations/travel 25 300
Entertainment 84 1,008
Alimony/child support
Charitable contributions
Required pension contributions
Magazine subscriptions/books
Other payments/expenses
Total Cash Outflows $1,576 $18,912
Net Cash Flow Cash Inflows Cash Outflows $159 $1,912
Danelle Washingtons personal cash flow statement.
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2.2 USING PERSONAL FINANCIAL STATEMENTS 31
paid. Thus, if you receive a bill on January 5 but dont pay it until February 1,
you record it as an expense in February, not in January. If certain amounts are
deposited directly to or withdrawn directly from your checking account, such as
paycheck deposits or car payments, you record them when they occur.
Identifying Your Cash Inflows
You should include as cash inflows all amounts of money you receive during the
period of time in question. You include any income you earn from a jobwages,
salaries, tips, and commission. Other sources of income may include
Scholarships.
Cash allowances or gifts from your parents or others.
Proceeds from the sale of assets.
Alimony or child support.
Government benefits, such as welfare, unemployment, or Social Security.
Investment earnings (i.e., income from dividends and interest).
Gambling winnings.
Notice that Danelle records her annual gross incomethat is, income before
taxes and expensesand records the taxes she paid during the year as cash out-
flows. Last year, she earned $9,500 from a part-time job and received a $1,300
scholarship and gifts of $200. She also took out a student loan in the amount
of $6,000. Her total cash inflows are therefore $17,000 for the year.
Detailing Your Expenditures
Whereas income is generally easy to identify and calculate, expenditures are more
difficult to track accurately. You can probably easily determine the big fixed
expensesexpenses that are a constant dollar amount each period, such as rent
and car loan payments. But few people do a good job of keeping track of their
variable expenses, which vary in amount from period to period, such as gro-
cery bills and gas money, even though these can be a big portion of their total
cash outflows.
You can see that on Danelles personal cash flow statement, $2,052 for gro-
ceries was one of her largest annual expenditures, exceeded only by her rent, at
$3,600, and her college expenses, at $3,996.
Small daily expenditures, such as money for parking meters or candy bars
from vending machines, are especially easy to overlook, but often these expen-
ditures can make the difference between achieving your financial goals and not
achieving them. Even if you just buy a latt at the coffee shop every weekday
afternoon on the way home from school or work, the seemingly small cost of
$3 per day adds up to $780 per yearenough to take a nice vacation or to add
to your investment portfolio.
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32 MONEY MANAGEMENT STRATEGIES AND SKILLS
If you spend money primarily by writing checks and using a debit card, its
a little easier to track your cash outflows because your bank statement and
check register are useful sources of information. Alternatively, you can track
your expenditures on a daily basis in a spending log in which you record all
your cash outflows for a month or longer. Your Personal Financial Planner
includes a spending log worksheet that you can use for this purpose. At the
end of the time period you have chosen, you can then total the amounts entered
in your spending log to put into your personal cash flow statement. You need
to do this for at least a month to be sure that youve included even the irreg-
ular cash outflows.
You should be careful not to alter your normal spending behavior tem-
porarily simply because youre recording everything. Suppose, for example, that
you never realized how much money you spent on latts until you began keep-
ing your spending log. Even if you plan to reduce your latt spending, you need
to incorporate this expense in your log so you can more realistically evaluate
your current finances. If you quit your latt habit during your spending log
period and decided to allocate the $780 per year to savings, what if you fell off
the wagon and returned to your prior spending behavior? At this stage, its better
to be brutally honest and record all spending, regardless of whether you plan to
make changes.
Calculating and Evaluating Net Cash Flow
After you enter and total your cash inflows and outflows on the personal cash
flow statement, you can calculate your net cash flow. Danelle calculates hers as
follows:
Net cash flow Total cash inflows Total cash outflows
$17,000 $18,912 $1,912
Based on Danelles personal cash flow statement, which shows a negative net
cash flow, she has been spending more than her income during the past year.
How did this happen? Her personal balance sheet gives some clues: Danelle
has credit card debt totaling $5,200 and total student loan debt of $18,000.
Because the personal balance sheet is cumulative, this amount represents debt
she has accumulated over time, not just in the past year. For example, we
know that she received $6,000 from a student loan this year, which means
she must already have had $12,000 in student loan debt at the beginning of
the year.
In addition to taking on more student loan debt, Danelle spent $1,912 more
than she earned last year, so these expenditures must have been made using
credit cards. The increased debt resulted in a decline in her net worth.
As you can see, Danelles income and spending habits have had a big effect on
her overall financial picture. We might be tempted to explain Danelles financial
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2.3 USING FINANCIAL RATIOS 33
position by pointing to her low income. However, an interesting economic truth
is that those who have more tend to spend more. If youre struggling to make
it on a students budget, you likely eat ramen noodles at least once a week and
make do with your current wardrobe. If youre a movie star earning millions of
dollars each year, you probably have more than one extravagant home, entertain
lavishly, and buy only designer clothes. But just because you have high income
doesnt mean that your finances are in good shape. Many seemingly well-off
people have gone bankrupt.
1. Define net worth, liquid assets, market value, and fixed expenses.
2. List some of your variable expenses.
3. What type of statement helps you track your spending?
S E L F - C H E C K
2.3 Using Financial Ratios
Financial ratios provide another important tool for evaluating your financial
condition. You can calculate your financial ratios from the information youve
collected on your personal financial statements, compare your ratios to recom-
mended targets, and track your ratios over time as a measure of your progress
toward achieving your financial goals. In this section, we examine ratios designed
to measure three aspects of your finances:
Liquidity.
Debt management.
Adequacy of savings.
The individual ratios and their calculations are explained in this section using
Danelle Washingtons financial information from Figures 2-1 and 2-2.
2.3.1 Measuring Liquidity
If you experience a total loss of income, if youre temporarily disabled or laid
off, you might need to meet your expenses without having your regular income.
The liquidity ratio tells you how many months you could pay your monthly
expenses from your liquid assets. This ratio is calculated as follows:
Liquidity ratio Liquid assets/Monthly expenses
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34 MONEY MANAGEMENT STRATEGIES AND SKILLS
2.3.2 Measuring Debt Usage
Everywhere we turn, it seems theres someone inviting us to borrow money to
buy something today instead of waiting until weve saved enough to pay cash.
Small wonder that one of the biggest financial problems U.S. households face is
that they have too much debt.
If your money style is to spend impulsively or if you tend to avoid financial
matters altogether, you may already understand the problems associated with
monthly payments on credit cards. Although debt is not inherently bad, pay-
ments made to lenders include interest charges and feesfunds that could be
better used to build your financial wealth. You can use your personal financial
statements to assess your debt management. Financial institutions such as banks
and mortgage companies use a variety of debt ratios when they evaluate you for
mortgage or car loans. We discuss three ratios in this section:
The debt ratio.
The debt payment ratio.
The mortgage debt service ratio.
These are the ratios that financial institutions most commonly use in their mort-
gage lending process.
The debt ratio measures the percentage of your total assets that youve
financed with debt. It is calculated as follows:
Debt ratio Total debt/Total assets
FOR EXAMPLE
What if Danelle Loses Her Scholarship?
Danelle has liquid assets equal to $1,500, the total value of her checking and
savings accounts (refer to Figure 2-1). Her annual expenses, from the cash
flow statement in Figure 2-2, are $18,912, and her monthly expenses total
$1,576. Thus, Danelles liquidity ratio (rounded to one decimal place) is
$1,500/$1,576 1.0
This means that Danelle could meet her expenses for only one month with-
out her regular income sources. Financial planners often recommend that you
have liquid assets sufficient to cover your expenses for three to six months,
so liquidity is a concern for Danelle, particularly at the end of the school year,
when she has depleted her student loan and scholarship funds. However, a
low liquidity ratio does not necessarily imply that she needs to increase her
allocation of funds to liquid assets. She may have other sources of funds that
can be tapped in an emergency, such as family loans or credit cards.
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2.3 USING FINANCIAL RATIOS 35
As your credit card balances increase, so does your debt ratio because credit card
purchases are usually for consumer goods that add littleif anyvalue to your
assets. For example, suppose you use a credit card to pay for dinner and a movie
for you and your significant other. This causes your debts to increase by, say,
$50, but your assets dont increase at all. The end result is that your debt ratio
goes up. However, the debt ratio generally declines as you get older because your
financial assets and home equity increase in value.
The debt payment ratio estimates the percentage of your after-tax income
that goes to paying required monthly minimum debt payments of all types,
including mortgage loans, student loans, car loans, and credit card payments.
The debt payment ratio is calculated as follows:
Debt payment ratio Total monthly debt payments/After-tax monthly income
Note that we use after-tax income in the denominator of the equation because
the purpose is to assess ability to pay. As you can see in Figure 2-2, Danelles
monthly after-tax income is $1,346 (calculated as monthly gross income of
$1,417 less $71 in income and payroll taxes). Her monthly debt payments total
$238 per month ($125 for credit cards plus $113 for her car loan). Using this
information, we can calculate Danelles debt payment ratio as follows:
$238/$1,346 0.177, or 17.7 percent
Bank lenders commonly require that total debt payments not exceed 33 per-
cent to 38 percent of gross income, which implies that the debt payment ratio
(based on after-tax income) could be even higher. By that measure, Danelles
17.7 percent debt payment ratio is not very high, but she will have to begin
paying her student loan a few months after graduation, so the ratio is likely
to rise in the near future. In addition, this ratio tends to understate Danelles
actual financial obligations because it doesnt include her required monthly rent
payments.
For most individuals, housing costs, either rent or mortgage payments, are
the largest monthly expenditure. The total monthly cost of a mortgage, includ-
ing the principal and interest paid to the lender, property taxes paid to the local
municipality, and homeowners insurance, is called the mortgage debt service.
Mortgage lenders commonly require that borrowers make a single monthly pay-
ment to cover all these expenses. The mortgage debt service ratio, which mea-
sures the percentage of your gross income that you pay out in mortgage debt
service alone, is calculated as follows:
Mortgage debt service ratio (Principal Interest Taxes Insurance)
/Gross monthly income
Both the debt payment ratio and the mortgage debt service ratio measure
your ability to pay your financial obligations. In determining your creditworthi-
ness, lenders commonly compare these or similar ratios to maximum values. For
example, a mortgage lender might require that your total debt payments be no
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36 MONEY MANAGEMENT STRATEGIES AND SKILLS
more than 35 percent of your gross income or that your total mortgage-related
expenses be no more than 25 percent of your gross income.
2.3.3 Measuring Savings
You can assess how well youre implementing your savings goals by tracking your
savings ratio over time. The savings ratio measures the percentage of your after-
tax income that is being allocated to savings and is calculated as follows:
Savings ratio Monthly savings/After-tax monthly income
Because the amount you have available for savings is whats left over from
your income after youve paid all your expenses and taxes, its quite possible to
have negative savings. This happens whenever your cash outflows exceed
your cash inflows. In that case, your savings ratio is negative as well. Danelle
Washingtons savings ratio is
$159/$1,346 11.8 percent
Because her negative savings ratio implies that, rather than saving, Danelle
is accumulating more debt, this financial situation cannot continue for long. As
she begins to develop her personal financial goals, Danelle will probably want
to include goals related to improving some of the financial ratios described here.
Financial advisors commonly recommend that households target at least a
10 percent savings ratio and that they attempt to increase this ratio over time.
SUMMARY
Its important that you develop a system for organizing and maintaining your finan-
cial records. You can use a personal balance sheet to figure out your net worth,
which is the total value of your assets minus the total value of your debts. You can
summarize your current inflows and outflows of cash by using a personal cash flow
statement. This financial statement helps you calculate net cash flow. Personal finan-
cial ratios can help you evaluate your current financial position, based on your per-
sonal balance sheet and cash flow statements. By comparing your ratios over time,
you can track your progress toward achieving your financial goals.
1. Define gross income.
2. What financial ratios measure your ability to pay your debt?
3. Where does the information for ratios come from?
S E L F - C H E C K
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KEY TERMS 37
KEY TERMS
Assets Everything you own, including liquid assets,
real and personal property, and investments.
Debt payment ratio A financial ratio that measures the percent-
age of disposable income required to make
debt payments.
Debt ratio Total debt divided by total assets.
Debts Everything you owe to others, including unpaid
bills, credit card balances, car loans, student
loans, and mortgages. Also known as liabilities.
Fixed expenses Expenses that are a constant dollar amount
each period.
Gross income Income before taxes and expenses.
Insolvency The inability to pay debts as they come due.
Liquid assets Cash and near-cash assets that can be easily
converted to cash without loss of value.
Liquidity ratio A financial ratio that measures the ability to
pay household expenses out of liquid assets
in the absence of regular income.
Market value The price that something can be sold for today.
Mortgage debt service The total dollar amount of monthly mortgage
principal, interest, property taxes, and home-
owners insurance.
Mortgage debt service ratio The ratio of mortgage debt service to gross
income.
Net worth The amount of wealth you would have left
after paying all your outstanding debts.
Personal balance sheet A statement that details the value of what
you own and what you owe to others to
arrive at an estimate of your net worth.
Personal cash flow statement A summary of income and expenditures over
a period of time.
Personal financial statement A statement that summarizes your financial
information.
Savings ratio A financial ratio that measures the percent-
age of after-tax income going to savings.
Variable expenses Expenses that vary in amount from period to
period.
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38 MONEY MANAGEMENT STRATEGIES AND SKILLS
ASSESS YOUR UNDERSTANDING
Go to www.wiley.com/college/bajtelsmit to assess your knowledge of money man-
agement strategies and skills.
Measure your learning by comparing pre-test and post-test results
Summary Questions
1. Because most IRS audits occur within three years of when a return is
filed, it is recommended that tax records be kept no more than five
years. True or false?
2. When saving documents, it is recommended that you keep utility bills:
(a) only until the next bill arrives.
(b) six months.
(c) one year.
(d) three years.
3. A personal balance sheet shows assets and debts at a single point in
time, and a personal cash flow statement reflects cash inflows and out-
flows that occur over a period of time. True or false?
4. Which of the following formulas is used to calculate personal net worth?
(a) Total assets Total debts
(b) Total assets Total debts
(c) Total debts Total assets
(d) Liabilities Unpaid bills
5. Which of the following would be the best definition of insolvency?
(a) having more liabilities than assets
(b) the inability to borrow any more funds
(c) having no savings
(d) the inability to pay bills on time
6. If you borrow money to buy a new car, which of the following items on
the balance sheet are affected?
(a) assets only
(b) debts only
(c) assets and debts
(d) unable to determine
7. The savings ratio is negative if cash outflows exceed cash inflows. True
or false?
8. If you have an insurance policy that has a cash surrender value:
(a) this represents an asset for you.
(b) this represents a debt for you.
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APPLYING THIS CHAPTER 39
(c) you enter no value on the balance sheet unless the policy is
surrendered.
(d) the premiums still due are subtracted from the surrender value to
arrive at market value.
9. You have estimated your total assets to be $10,000, your liquid assets to
be $2,000, and your total debts to be $11,000. Your net worth is
$2,000. True or false?
10. Don has assets of $5,000, of which $1,800 are in checking and savings
accounts. His annual expenses are $15,000. Dons liquidity ratio is:
(a) 0.333.
(b) 3.00.
(c) 0.12.
(d) 1.44.
Applying This Chapter
1. Identify the purpose for saving each of the following documents, if any,
and how long you should save it:
(a) Visa bill
(b) apartment rent receipt
(c) bank checking account statement
(d) tax return
2. Identify whether each of the following is an asset, a debt, or neither:
(a) credit card balance
(b) weekly employment earnings
(c) car
(d) rent paid to landlord
(e) checking account
3. Use the following personal balance sheet to calculate the net worth:
Assets Liabilities
Bank accounts $3,000 Current bills $1,500
Car $5,000 Student loan $10,000
Personal assets $2,000 Car loan $3,000
4. Using the personal balance sheet from Question 3, calculate total liquid
assets.
5. Using the personal balance sheet from Question 3, what is the debt ratio?
6. Using the personal balance sheet from Question 3, and assuming that
monthly expenses total $1,200, calculate the liquidity ratio.
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40 MONEY MANAGEMENT STRATEGIES AND SKILLS
7. The Sandell family reports the following financial information:
Checking and savings account $ 3,000
Monthly after-tax income $ 2,500
Total monthly expenses $ 2,000
Monthly savings $ 500
Total debt $10,000
Total assets $40,000
Calculate the Sandells liquidity ratio.
8. Calculate the Sandells debt ratio.
9. Calculate the Sandells savings ratio.
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YOU TRY IT
Can You Afford a New Car?
Suppose you have your eye on a new car, and your
monthly after-tax income is $2,000. Your monthly ex-
penses are as follows:
Car insurance: $100
Rent: 900
Groceries: 300
Entertainment: 200
Utilities: 200
Credit card payment: 100
Other: 100
What is your net cash flow? Can you afford that new
car? Why or why not?
Whats Wrong with This Picture?
Melody and Charles Verona have been married for less
than one year and currently live in a one-bedroom
apartment. They would like a bigger place to live and,
with two incomes, they think they could afford to make
mortgage payments on a small home or condominium.
Unfortunately, they dont have enough money for a
down payment yet, so they want to begin saving for
this purpose. Over the past few months, Melody has
been dismayed to find that they always seem to be a lit-
tle short on cash at the end of the month. She decides
to sit down with Charles to look more carefully at their
spending habits and begin making a plan that will en-
able them to buy a house. The Veronas have collected
the following financial information in preparation for
evaluating their current finances and determining how
much to save:
Cash Inflows Gross Income After-Tax Income
Melody $22,000 $18,000
Charles 28,000 22,400
Cash Outflows Monthly
Groceries $400
Eating out 200
Rent 950
Credit card payments 200
Telephone 50
Utilities 150
Car loan payments 360
Car expenses and fuel 160
Clothing 100
Entertainment 150
Health club membership 60
Travel and vacations 100
Assuming that these cash flows are accurate and com-
plete, what is the Veronas net monthly cash flow? If the
Veronas allocate their net cash flow to savings each
month and they can earn 4 percent after taxes, how
much will they have in the account after two years?
What is a possible explanation for why the Veronas are
having cash flow problems each month? What would
you suggest they do to identify the reasons for this
problem?
Net Worth
Construct a personal balance sheet by itemizing your
assets and debts. You can use the blank forms in the
Personal Financial Planner to do this. If you arent sure
of an items value, estimate as best as you can. What is
your net worth as of today?
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