Financial Statements and Analysis (L6)

Question 1

Personal Financial Statements

Answer 1

• PRIMARYLY used as a scoring mechanism for capturing and analyzing an individual’s financial position and performance
• Financial Statement included:
• Balance Sheet (“Statement of Financial Position or Net Worth Statement”)
• Income and Expense Statement (“Statement of Cash Flow”)

Question 2

Balance Sheet

Answer 2

Question 3

Balance Sheet LIMITATIONS

Answer 3

Balance Sheet DOES NOT explain the following:

○ Why or how the asset increased in value

○ Whether the client bought more of the asset or did the asset appreciate?

○ Why or how an asset/liability appears on the balance sheet?

○ Whether the client purchased an asset on 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?

Question 4

Income and Expenses Statement

Answer 4

Question 5

Limitations of Statement of Income and Expenses (Cash Flow Statement)

Answer 5

• Cash Flow Statement DOES NOT:
  ○ Consider an ER’s contribution s to retirement plans
  ○ Capture and report the giving or receiving of gifts/inheritances

Question 6

Financial Statement Analysis

Answer 6

• Gives us insight to a client’s STRENGTHS and WEAKNESS
• Allows us to answer questions related to:
  ○ How well the client manages debt
  ○ How well the client is progressing toward his financial goal
  ○ How well the client is able to meet short-term obligations

Question 7

Limitations to Financial Statement Analysis

Answer 7

ONLY PROVIDES US WITH A HISTORICAL PERSPECTIVE –> NOT PREDICTIVE OF THE FUTURE

Question 8

Ratio Analysis

Answer 8

• Objective:
  ○ Gain additional insight to the financial situation and behavior
  of the client
  ○ Generate questions for the client to answer to further gain
  insight
• Categories of Ratios
  ○ Liquidity Ratios ==> measure the ability of a client to meet
  short-term or current liabilities○ Debt Ratio/Debt Analysis ==> indicate how well a person
  manages their overall debt○ Performance Ratios ==> Assess the financial flexibility of the
  client, as well as the client’s progress towards goals

Question 9

Liquidity Ratios

Answer 9

Question 10

Debt Ratios

Answer 10

Question 11

Buying vs. Renting (Leasing)

Answer 11

• Appropriate to rent or lease if:
  ○ The clients time in the property is going to be short (1-3 years)
• Appropriate to Buy, if:
  ○ The clients 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 expenses associated with the
  client’s primary residence

Question 12

Adjustable-Rate Mortgage (ARM)

Answer 12

○ Appropriate when the clients 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

Question 13

REVERSE MORTGAGE

Answer 13

○ The homeowner receives monthly PMT or LUMP SUM from a bank while still living in the house

○ Repayment of the outstanding mortgage occurs at the homeowner’s death

○ Appropriate to generate income for elderly homeowners

○ Available if the homeowner is age 62 or older

Question 14

Performance Ratios

Answer 14

Question 15

Limitations of Financial Statement Analysis

Answer 15

• Inflation
  ○ Makes it difficult to compare financial statements from one
  period to the next
• Use of Estimates
  ○ Any type of net worth calculations includes personal use
  assets
  ○ Personal use assets are typically stated at an ESTIMATED FMV
• Benchmarks
  ○ There are very few benchmarks for personal financial ratios
  ○ Benchmarks serves as a rule of thumb, but individual
  circumstances may cause a benchmark to be irrelevant