Asset Types, Balance Sheets, Income Statements, and Time Value of Money

Liquid assets

  • Definition: assets that you can spend easily and quickly. They are cash-like or very liquid forms of money.
  • Examples: cash, checking accounts, savings accounts.
  • Certificates of Deposit (CDs): somewhat restricted savings instrument. CDs typically offer higher interest than regular savings (e.g., CDs might yield ~2–3%), but restricts access to funds until maturity.
  • Short-term liquid treatment: if you can withdraw CD funds within the year, you can still count them as liquid assets for short-term analysis.
  • Relationship to other assets: liquid assets are contrasted with investments and illiquid assets; the key is ease of access and speed of conversion to cash.

Investments

  • Types: stocks, bonds, business ownership, retirement funds.
  • Liquidity and access: generally liquid enough to tap if needed, but not as instantly accessible as cash or checking accounts.
  • Special cases:
    • Retirement funds: early withdrawal may incur penalties and restrictions.
    • Business ownership: selling ownership can be harder; may require finding buyers, possible partner buyouts.
    • Stocks and bonds: typically easier to sell than private assets, but not as liquid as cash.
  • Real property vs. other assets:
    • Real property refers to physical property like buildings (e.g., an apartment building) which can be a form of investment but is typically illiquid.

Real property

  • Definition: property that is real estate or land/buildings.
  • Examples: apartment buildings, rental properties, commercial real estate.
  • Liquidity considerations: generally less liquid than stocks or cash; sale can take time and involve pricing, closing costs, and market conditions.

Personal property

  • Definition: everything else you own that isn’t attached to the ground.
  • Examples: vehicles, furniture, appliances, jewelry.
  • Valuation approach: valued at fair market value for the purposes of these notes, not necessarily at purchase cost.

Fair market value vs. cost and accounting context

  • Fair market value (FMV): the price you could reasonably obtain if you sold the asset in an orderly transaction between willing buyers and sellers.
  • Distinction from cost basis: FMV can differ from what you originally paid for the asset; the FMV reflects current market conditions.
  • Important caveat for this course: FMV is used for personal financial statements here, not for financial accounting. This class focuses on what the asset is worth now, not on historical cost or depreciation values used in accounting records.
  • Why this matters: for a personal financial statement, the goal is to understand current worth and liquidity rather than how much was paid or how it’s depreciated in accounting terms.

Balance sheet basics (assets and liabilities)

  • Purpose: snapshot of what you own (assets) and what you owe (liabilities) at a given point in time.
  • Timing: typically prepared as of a date (e.g., end of the month).
  • Classification:
    • Assets: listed by category (liquid assets, investments, real property, personal property).
    • Liabilities: debts and obligations.
  • Current portion vs long-term:
    • For personal financial statements, long-term debt is split into the portion due within the next year (current portion) and the rest as long-term.
    • The idea is to report only the portion due in the next 12 months as current liabilities and keep the remaining balance under long-term liabilities.
  • Practical takeaway: at the end of the period, tally all assets and all liabilities and categorize them accordingly to derive net worth.

Income statement basics

  • Purpose: records income and expenses over a period of time (not a single date).
  • Timing: defined by a period (e.g., April 2025 or a monthly period).
  • What to record:
    • All income (cash inflows).
    • All expenses (cash outflows): operating expenses, asset purchases (e.g., furniture, vehicles), entertainment, recreation, etc.
  • Net result: income minus expenses equals net cash left over after the period considered.
  • Focus for this class: understanding cash flows over a period rather than the balance at a single point in time.

Time value of money (concept and significance)

  • Core idea: a dollar today is worth more than a dollar in the future due to factors like earning potential, inflation, and risk.
  • Temporal comparisons: value changes over time; forward-looking and backward-looking valuations are used to compare money across time.
  • Two key questions:
    • Present value (PV): what is a future amount worth today?
    • Future value (FV): what is a current amount worth in the future?
  • Common framing: a lump sum received in the future should be discounted to its present value to compare with today’s opportunities; conversely, a current amount can be projected forward to see what it will become.
  • Example intuition: if you expect to receive a large sum in the future, you can determine how much that future sum is worth today given a discount rate (often tied to expected return or interest rates).

Present value and future value formulas (with key variants)

  • Single future value from today:
    • FV=PV×(1+r)nFV = PV \times (1 + r)^n
  • Present value of a future amount:
    • PV=FV(1+r)nPV = \frac{FV}{(1 + r)^n}
  • Present value of an annuity (regular payments):
    • PVannuity=Pmt×1−(1+r)−nrPV_{\text{annuity}} = Pmt \times \frac{1 - (1 + r)^{-n}}{r}
  • Future value of an annuity (regular payments):
    • FVannuity=Pmt×(1+r)n−1rFV_{\text{annuity}} = Pmt \times \frac{(1 + r)^n - 1}{r}
  • Use of r: discount/interest rate; n: number of periods; PV: present value; FV: future value; Pmt: periodic payment.
  • Practical note: in most financial calculators, one of the inputs (PV, FV, or Pmt) is entered as a negative value to reflect cash outflow vs inflow due to the way the calculator handles signs.

Practical example from the lecture

  • A typical assumption for a reasonable long-term return is around 6% (often derived from stock market averages).
  • Example 1: Present value of receiving $10,000 in 10 years at 6% interest:
    • Using the formula: PV=FV(1+r)n=10000(1.06)10≈5,600PV = \frac{FV}{(1 + r)^n} = \frac{10000}{(1.06)^{10}} \approx 5,600
    • Interpretation: about $5,600 today is worth $10,000 in 10 years at 6% annual return.
  • Example 2: Present value of an amount with a given future value and rate (quick calculator demonstration): if you expect $10,000 in the future, at 6% annual rate, the present value is approximately $5,600 (as shown above).
  • Example 3: Future value of a present amount (reverse question): if you have $1,000 today and want to know what it will be worth in the future, you use FV=PV(1+r)nFV = PV(1 + r)^n with the chosen r and n.
  • Emphasis: these calculations can be done with online calculators (e.g., calculator.net) or on your phone/computer; the top tab is usually labeled for the quantity you want to compute (FV or PV).

Using financial calculators and online tools

  • Common steps:
    • Choose the calculation goal: future value or present value.
    • Enter inputs:
    • Number of periods (e.g., years) n.
    • Interest rate per period r (e.g., 6%).
    • Present value PV (or future value FV depending on the direction of the calculation).
    • Payment Pmt if there are regular payments (for annuities); set to 0 if there are none for this simple example.
    • Note the sign convention: one of PV, FV, or Pmt is typically entered as negative to reflect cash outflow vs inflow.
  • Example workflow from the transcript:
    • To compute future value with PV = $1,000 and no ongoing payments, set Pmt = 0 and use FV tab with r around 6–7% and n as the number of years; the calculator will return FV.
    • To compute present value of a future amount (e.g., FV = $10,000 in 10 years at r = 6%), use PV = $5,600 (approximately) as the result.
  • Accessibility: you can perform these calculations on calculator.net or via smartphone calculators, with the same underlying formulas.

Key practical takeaways for personal finance planning

  • Know your asset types and their liquidity to manage emergencies and near-term needs.
  • Distinguish FMV (what it’s worth today) from cost; use FMV for personal statements and planning, not purchase price or historical cost.
  • Use the balance sheet to assess net worth at a point in time, and the income statement to assess cash flow over a period.
  • Apply time value of money principles to evaluate investment opportunities, savings goals, and retirement planning by comparing present values and future values.
  • When using calculators, understand the inputs and sign conventions; practice with common scenarios (lump-sum PV, lump-sum FV, and simple annuities) to build fluency.
  • Be mindful of real-world caveats: early withdrawal penalties for retirement funds, potential liquidity constraints for real estate or business ownership, and market conditions affecting fair market values and liquidity.

Quick references and formulas recap (LaTeX)

  • Future value from present value:
    • FV=PV×(1+r)nFV = PV \times (1 + r)^n
  • Present value of a future amount:
    • PV=FV(1+r)nPV = \frac{FV}{(1 + r)^n}
  • Present value of an annuity:
    • PVannuity=Pmt×1−(1+r)−nrPV_{\text{annuity}} = Pmt \times \frac{1 - (1 + r)^{-n}}{r}
  • Future value of an annuity:
    • FVannuity=Pmt×(1+r)n−1rFV_{\text{annuity}} = Pmt \times \frac{(1 + r)^n - 1}{r}
  • Example numeric check:
    • If you will receive FV=10,000FV = 10{,}000 in n=10n = 10 years with an annual rate r=0.06r = 0.06, then
    • PV=10,000(1.06)10≈5,600PV = \frac{10{,}000}{(1.06)^{10}} \approx 5{,}600
  • Example rate reference: typical long-term return assumption used in many educational contexts is around r=6%r = 6\% (i.e., 0.06).