Basic Building Blocks of Successful Financial Management Review Questions & Answers
1.What are the three primary components of the financial planning process? Why is it graphically shown as a pyramid?
The building blocks of financial management concentrate on wealth -- the protection, accumulation, and distribution of wealth. Visualizing the three blocks as a pyramid serves to remind us that the pinnacle, or peak, can only be built on a firm foundation of interlocking components.
Notice that the foundation, or wealth protection, precedes wealth accumulation. Although this may seem counter-intuitive, remember that the initial strategies of cash management, tax management, risk management, and the accumulation of an emergency fund are fundamental to a sound financial plan. In other words these plans must be in place before you can focus on wealth accumulation.
Fundamental to wealth accumulation is the identification of short- and long-term financial goals and the development and implementation of plans to achieve those goals. Wise use and management of credit is critical to successful wealth accumulation.
While it is everyone’s goal to postpone wealth distribution until far into the future, estate planning strategies, the focus of this step, may be needed early in the life cycle to protect your property, your heirs, and your wishes. Of course, reviews of all financial planning strategies should occur periodically, but are particularly important with changes in the tax laws or your personal or employment situation.
3.Explain the two financial statements that are critical to effective cash management.
A net worth statement, or balance sheet, summarizes the assets and liabilities of a household. In other words, it compares today’s market value of all your assets with today’s outstanding balance on all your debts. Because these amounts change often, it is recommended that you complete the balance sheet on the same day every year as a standard for comparison.
A cash flow statement, also known as an income and expense statement, compares all sources of income and outflow over a period of time, typically one year. Summarizing income and expenses, regardless of the period of time, helps you monitor how you are managing your finances and provides useful information for future financial decisions.
Experts recommend an emergency fund equal to 3 to 6 months of expenses; however, the exact amount varies with the situation of the individual or household. Keep in mind the objective is not to save less, but to have more funds in higher yielding accounts. Your age, health, job outlook, insurance coverage, access to credit, and other factors unique to your financial situation affect the exact amount needed. For example, access to low-cost credit and multiple sources of income could allow a household to have less specified for an emergency fund, with the plan that credit could be used for larger emergency expenses. Amounts beyond the 3 months of expenses, for example, could then be set aside for other savings goals or investments. You should consider having a larger emergency fund, or amount closer to the 6 months amount, if any of the following characterize your situation.
To minimize penalties for early withdrawal of funds (e.g., from a CD that has not matured) and to maximize interest earnings, you might consider subdividing your emergency fund among a combination of accounts provided by financial institutions (e.g., bank, credit union, etc.), mutual fund companies (e.g., money market mutual fund, short-term bond fund), or the U.S. Treasury. Be sure to consider convenience, safety (e.g, availability of FDIC insurance) and cost to open and operate the account when choosing your combination of products.
Risks associated with yourself (life, health, disability, liability) and your property (homeowner’s or renter’s, auto, liability) represent potentially huge financial losses. Whereas excessive insurance is not recommended, adequate insurance coverage to protect from possible risk exposures is a cost-effective strategy. In other words, everyone pays a little, to subsidize the larger losses that periodically occur to some people. More importantly, you avoid going into debt or “robbing” funds saved for other goals by including the cost of insurance in your annual financial plan. To control costs, be sure to shop around.
Some people like to receive a large annual tax refund. But in reality, they are providing the government an interest-free loan. Since banks don’t make interest-free loans, perhaps neither should you!! Review your tax withholding, and include the “extra” income in your annual budget or savings plan.
Taxpayers who sell their primary residence, after living there for 2 of the last 5 years, can exclude $250,000 of profit from capital gains taxes for an individual filer, or $500,000 for a couple filing jointly. Other qualifications include:
Identifying $MART financial goals to guide your personal, career, and financial success help you to:
“Red flags” of debt include:
Eliminating debt frees money for savings and investments, and may actually “earn” you a greater return. Does your savings account or other investment guarantee a return of 25% per year? Of course not, but paying off an 18% credit card debt “guarantees” you an after-tax return of 25% (18% / .72 = 25%) because you avoid future interest payments. Available, unused credit can supplement an emergency fund in the event of a major expense, thus freeing money to be moved into higher earning accounts. On the contrary, with high credit balances, you actually need a “larger” emergency reserve, which although recommended, in reality rarely occurs.
For many, a home is a principal component of their wealth accumulation. In areas with rapid real estate appreciation, the return can be significant. In areas with low real estate appreciation, a home offers little more than a service – shelter – with no significant appreciation in value. These factors should be considered when purchasing your home, and making decisions about the amount needed to save for retirement or other long-term goals. The equity accumulated may be tapped for a loan, but should be done with extreme caution.
Your investment plan should be built on a foundation of the following:
Several common strategies apply to both of these typical wealth accumulation goals:
Historically the retirement three-legged stool consisted of Social Security, employer retirement benefits (e.g., a pension) and personal savings. Aside from the fact people are living longer and expenses are greater, the stool is increasingly “shaky” today. Approximately a third of Americans admit that they are not saving for retirement, although there is growing concern over the future of Social Security. Both of these sources were planned as supplements to company benefits, which are not as stable as in the past. Benefits offered by employers have been reduced, and increasingly saving for retirement has become the responsibility of the employee. For too many Americans, a fourth leg of continued employment and steady income during retirement will be necessary. You can avoid this dilemma by starting early to save for retirement. Remember that time and tax savings are on your side.
Dying intestate means dying without a will; state law will then determine the distribution of any assets. Regardless of the amount of wealth accumulated, it is important to explore how state law would affect your property and your wishes for its use and distribution. Naming guardians for children is another important reason to write a will.