Financial Statements and Analysis

Debt Ratios and Debt Analysis

indicate how well a person manages their overall debt. • Consumer debt payments should not exceed 20% of NET income. • Housing debt should be less than or equal to 28% of GROSS income. • Housing plus all other recurring debt should be less than or equal to 36% of GROSS income.

Liquidity Ratios

measure the ability of a client to meet short-term or current liabilities. - Current Ratio

fair market value

the price at which a willing buyer is willing to buy and the price at which a willing seller is willing to sell

When is it appropriate to use a variable rate mortgage?

when income is expected to significantly increase in the future or you anticipate staying in the house for a short period of time.

What are some limitations of a Cash Flow Statement?

• A Cash Flow Statement does not: - Consider an employer's contributions to retirement plans (it only captures employee contributions). - Capture and report the giving or receiving of gifts or inheritances.

Balance Sheet/ Statement of Financial Position/ Net Worth Statement

• List of assets, liabilities and net worth. • A balance sheet is a snapshot of account balances at a "moment in time." • Proper dating is, "As of December 31, 20xx." • Formula: Assets - Liabilities = Net Worth

Assets

• Property that is owned or partially owned by client. - Stated at fair market value (the price at which a willing buyer is willing to buy and the price at which a willing seller is willing to sell).

It's appropriate to buy if:

• The client's time in the property is going to be long (>3 years). • If the client's goal is to build equity. • If the client is in a high marginal tax bracket because of the income tax deduction for interest expense associated with the client's primary residence.

Liabilities

• debt obligations that are owed by the client. • Liabilities are stated at principal outstanding. • Liabilities are classified according to the timing of when they are due, which includes either current or long-term liabilities. - Credit Cards, Mortgage, Auto Loan, Student Loan

Savings Ratio

[Annual Savings (Employee + Employer Contributions)]/ Annual Gross Income - It's important to include employer contributions to 401(k), profit-sharing plans, etc., as part of the savings ratio calculation. - A benchmark savings ratio target is 10-12% of gross income if the client starts saving before age 32. - If a client waits to begin saving at 45 or 50, the rate may be 20-25% of gross income.

Housing & All Other Debt Ratio - 36%

[Monthly Housing Costs (P+I+T+I) + All Other Recurring Debt Payments]/ Monthly Gross Income - Ratio should be 36% or less - P = Principal - I = Interest - T = Taxes (Property) - I = Homeowners Insurance - All other recurring debt includes: auto, student loans, boat, credit card and any other type of monthly debt.

Housing Ratio - 28%

[Monthly Housing Costs (P+I+T+I)] / Monthly Gross Income - Ratio should be 28% or less - P = Principal - I = Interest - T = Taxes (Property) - I = Homeowners Insurance

Your client's current assets are $15,000. Monthly nondiscretionary expenses are $5,000 and monthly discretionary expenses are $2,000. What is the client's emergency fund? a) 3.0 months b) 2.1 months c) 5.5 months d) 6.5 months

a) 3.0 months $15,000/$5,000 = 3

When preparing a client's statement of financial position, which of the following is true? a) A reserve liability account for taxes owed on the sale of assets should be listed. b) Assets with more volatility should be listed first in the investment assets section. c) All expenditures should be categorized as fixed or variable. d) Anticipated liabilities, such as a potential car purchase in 10 years should be reported and recorded at its net present value.

a) A reserve liability account for taxes owed on the sale of assets should be listed.

Performance Ratios

assess the financial flexibility of the client, as well as the client's progress towards goals. - Savings Ratio - Rate of Return on Investments (ROI)

The value of a clients house will be listed at what price in the personal use asset section of the balance sheet? a) Cost b) Insured Price c) Outstanding Mortgage Balance d) Fair Market Value

d) Fair Market Value

Which of the following is NOT a personal use asset? a) Automobile b) Primary Residence c) Furniture d) Pension Plan

d) Pension Plan

Emergency Fund

- Clients need 3 - 6 months in nondiscretionary expenses in an emergency fund. - Nondiscretionary expenses include only those expenses that do not go away if you lose your job, such as mortgage, utilities, food, car loan, property taxes and insurance premiums. - Nondiscretionary expenses do not include income taxes, payroll taxes and contributions to a retirement savings account. - Emergency Fund = Current Assets ÷ Monthly Nondiscretionary Expenses

Financial Statements & Financial Statement Analysis

- Help the planner to analyze an individual's financial position and performance - Balance Sheet/ Statement of Financial Position/ Net Worth Statement - Income and Expense Statement/ Statement of Cash Flows - Financial statement analysis gives insights into the client's strengths and weaknesses. - How well does the client manage debt? - How well is the client progressing toward their financial goal? - How well is the client able to meet short-term obligations?

Ratio Analysis

- Helps the planner to gain additional insight into the financial situation and behavior of the client. - Can be used to generate questions for the client to answer. • For example, if a client has a low savings rate and high variable expenses, can the client adjust any variable expenses to increase her savings rate?

Current Assets or Cash & Cash Equivalents

- Includes anything the client expects to convert to cash within 1 year. - Cash, MM, CDs < 12 Months

What are some limitations of Financial Statement Analysis?

- Inflation - makes it difficult to compare financial statements from one period to the next. - Use of Estimates - Any type of net worth calculation includes personal use assets. Personal use assets are typically stated at an ESTIMATED fair market value. - Financial statement analysis only provides us with a historical perspective. It is not predictive of the future.

Current Ratio

- Measure of a client's ability to meet short-term obligations. - Current assets include: cash and cash equivalents, marketable securities such as certificates of deposit less than 12 months in maturity, money market, savings, cash and accounts receivable. - Current liabilities include: credit cards and short-term debts due in less than 12 months. - Current Ratio = Current Assets ÷ Current Liabilities.

Current Liabilities

- Obligations that are due within the next 12 months. - excludes interest unless already incurred. • For example, includes credit cards, taxes payable and any unpaid bills such as utilities, cable, cell phone bills, etc.

Reverse Mortgage

- The homeowner receives a monthly payment or lump sum from a bank while retaining the right to live in the house. - Repayment of the outstanding mortgage occurs at the homeowner's death. - A reverse mortgage is appropriate to generate income for elderly homeowners. - Available if the homeowner is age 62 or older.

Long-Term Liabilities

- The remaining balance on any outstanding debt beyond 12 months. • For example, includes the outstanding balance on a loan for the client's house, car, boat or any other outstanding loan.

What are some limitations of a Balance Sheet?

- Why or how an asset increased in value. - Whether the client bought more of the asset or did the asset appreciate? - Why or how an asset or liability appears on the balance sheet. - Whether the client purchased an asset or inherited the asset? - The balance sheet does not explain changes in net worth. - Whether the increase in net worth is the result of added savings, inherited assets, appreciation of assets, or debt retirement?

Statement of Cash Flows/ Statement of Income and Expenses

- a listing of income, savings, expenses and taxes. - Income includes salary, interest, dividends and business income. - Savings is an outflow to retirement plans, education savings or any other savings account. - Expenses are both variable and fixed expenses. Examples of fixed expenses include: mortgage, car payment, boat payment, student loan payment and, generally, any expense that remains constant each month. Examples of variable expenses include: car repairs, entertainment expenses, utilities, charitable contributions and, generally, any expense over which the client can exercise control. • Presents income and expenses "over a period of time." • Proper dating would be, "For the Year 20xx."

Nondiscretionary expenses

- only those expenses that do not go away if you lose your job, such as mortgage, utilities, food, car loan, property taxes and insurance premiums. - Nondiscretionary expenses DO NOT include: income taxes, payroll taxes and contributions to a retirement savings account.

Invested Assets

- stocks, bonds, mutual funds, business ownership, IRA, Brokerage Account, CDs > 12 Months

As a general rule of thumb, what percentage of a client's gross income should they save annually if they start before age 32?

10-12%

A general rule of thumb for Consumer debt payments is that the amount should not exceed what percentage of NET INCOME?

20%

As a general rule of thumb, what percentage of a client's gross income should they save annually if they start after age 45?

20-25%

A general rule of thumb for Housing debt payments is that the amount should not exceed what percentage of GROSS INCOME?

28%

How many months of non-discretionary expenses should a client have saved in an Emergency Fund?

3-6 months

A general rule of thumb for Housing plus all other recurring debt payments is that the amount should not exceed what percentage of GROSS INCOME?

36%

At what age may a homeowner participate in a reverse mortgage?

62

Net Worth Formula

Assets - Liabilities = Net Worth

Personal Use Assets

Car, furniture, clothing, boat, House, Jewelry, Furniture

It's appropriate to rent or lease if:

The client's time in the property is going to be short (1-3 years).

Adjustable Rate Mortgage (ARM)

- An ARM is appropriate when the client's time in property will be short (1-3 years). - A 2/6 ARM means the interest rate cannot increase more than 2% per year or 6% during the term of the loan. Example: Shania enters into an adjustable rate mortgage at 4%, when 30-year mortgages are 6.5%. The ARM is a 2/6 with no penalty for early repayment. What is the maximum interest rate Shania could expect to pay on this ARM? 4% + (2% + 2% + 2%) = 10% The risk is that the mortgage will become too expensive in years 2 and 3 if interest rates increase each year for three years.

Rate of Return on Investments (ROI)

ROI = (Ending Investments - Beginning Investments - Savings - Gifts Received)/ Average Invested Assets *Average Invested Assets = (Beginning Investments + Ending Investments)/ 2 - ROI should also be compared with an appropriate benchmark based on a client's age and risk tolerance. - ROI provides some insight as to the likelihood of achieving goals.