Financial Fundamentals - Ch 4

Question 1

Name the 2 Principal Financial statements.

Name the 2 Supplementary Financial Statements

Answer 1

Principal Financial Statements:
-The Balance Sheet (A Statement of Financial Position or A Statement of Assets, Liabilities and Net Worth)
-Income Statement

Supplementary Financial Statements:
-Statement of Net worth
- Cash Flow Statement

Question 2

Define a Balance Sheet

Answer 2

• Referred as statement of financial position
• It shows the date at a “Moment in Time “

-represents the accounting for items the client “owns” (assets) and items that are “owed” (liabilities).

-Difference between assets and liabilities = the owner’s equity (net worth).

Question 3

Define Cash and Cash equivalents

Answer 3

Cash

cash equivalents (current assets) highly liquid, can be converted to cash (within the next 12 months) with little to no price concession from the principal amount invested

Question 4

What are the Investment assets within a Balance sheet ?

Answer 4

Investment assets -
-retirement accounts (401(k) plans,
-profit sharing plans,
-IRAs, annuities)
* brokerage accounts
* education funds
* cash value in a life insurance policy
* business ownership interests
* the vested portion of any pension plan
* rental property
* other: investment partnership interests, oil and gas interests, collections (such as art)

Question 5

Define Personal Use assets within a balance sheet

Answer 5

Personal use assets are those assets that maintain the client’s lifestyle.
- personal residences
* automobiles
* furniture
* clothing
* boats
* jet skis
* vacation homes
* electronics (television, stereo, iPad, etc.) * collectibles (art, antiques, coins)2

Question 6

Define Liabilities on a balance sheet

Answer 6

Liabilities -
-financial obligations that the client owes to creditors. To satisfy a liability, either a client-owned asset or some other economic benefit must be transferred to the creditor

• short-term or current liabilities (expected to be paid within one year) * long-term liabilities (expected to be paid beyond one year)

Question 7

Define Net Worth

Answer 7

Assets - Liabilities = net worth

The net worth of the client as reflected on the balance sheet represents the amount of total equity (assets - liabilities = net worth) a client has accumulated as of the date of the balance sheet.

Question 8

Assets on a balance sheet are defined as ?

Answer 8

The balance sheet formula is:

Assets = Liabilities + Net Worth.

Question 9

Josephine buys a house for $400,000.
She makes a $50,000 down payment and finances the balance with a mortgage. How is her net worth impacted from this transaction?

Answer 9

Josephine exchanges one asset ($50,000 cash) for another ($400,000 home) and increases her liabilities ($350,000 mortgage).
Therefore, her net worth is not impacted by purchasing the house. However, as time goes by, the increase or decrease in the value of the house will impact her net worth as will the reduction in the principal obligation of the mortgage.
______________________________________________________________________
Assets - Liabilities = Net Worth
cash (50,000) (50,000)
Home 400,000 400.,000
Mortgage 350,000 (350,000)

Net Impact 350,000 350,000 0

Question 10

Define the 5 most common forms of ownership are:

Answer 10

• Sole Ownership
• Tenancy in Common
• Joint Tenancy with Right of Survivorship (JTWROS)
• Tenancy by the Entirety
• Community Property

Question 11

Define Sole Ownership.

Answer 11

Sole ownership
The complete ownership of property by one individual who possesses all ownership rights associated with the property, including the right to use, sell, gift, alienate, convey, or bequeath the property

Question 12

Define Tenancy in common.

Answer 12

Tenancy in common - Joint ownership w/ non-spouses

An interest in property held by two or more related or unrelated persons.
Each owner is referred to as a tenant in common.
Tenancy in common is the most common type of joint ownership between non-spouses.
Each person holds an undivided, but not necessarily equal, interest in the entire property

Question 13

Define Joint Tenancy with Right of Survivorship (JTWROS)

Answer 13

spouses own joint property.

An interest in property held by two or more related or unrelated persons called joint tenants.
Each person holds an undivided, equal interest in the whole property.

Question 14

Define Tenancy in Entirety.

Answer 14

Joint Ownership with spouses, cannot be severed without the consent of the other spouse.

Tenancy by the entirety is similar to property owned as JTWROS between spouses because property ownership is automatically transferred to the surviving spouse upon death.
The two tenants own an undivided interest in the whole asset.

Question 15

Define Community Property.

Answer 15

Joint ownership with spouses - own an equal undivided interest in all property accumulated and Income during their marriage.

Community property is a civil law statutory regime under which married individuals own an equal undivided interest in all property accumulated during their marriage.
During marriage, the income of each spouse is considered community property.
Property acquired before the marriage and property received by gift or inheritance during the marriage retains its status as separate property.

States following the community property regime: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.

Question 16

Define an important distinction between
sole ownership, tenants in common, and sometimes community property versus JTWROS and tenancy by the entirety.

Answer 16

Property owned JTWROS and tenancy by the entirety
-avoids probate and the decedent’s interest transfers automatically.

sole ownership, tenants in common,
-Pass THRU Probate

Question 17

Define Fixed expenses.

Answer 17

Fixed expenses remain static for a specific period of time, regardless of changes in spending or income.

Examples include: * Mortgage Payment * Car Payment * Boat Payment * Student Loan Payment * Property Taxes * Insurance Premiums * Federal and State Income Taxes Withheld * Social Security Payments Withheld

Question 18

Define Variable expenses.

Answer 18

Variable expenses are more discretionary than fixed expenses over the short term.
A client has more discretion over the amount of variable expenses, which often presents an opportunity for savings if variable expenses are closely monitored and controlled.
Examples of variable expense accounts include: * Entertainment Expenses * Vacation Expenses * Travel Expenses * Charitable Contributions

Question 19

Define the net discretionary cash flow formula from an income statement.

Answer 19

Income – Savings – Expenses – Taxes = Net Discretionary Cash Flow

Net discretionary cash flow is a critical item when analyzing the statement of income and expenses.

Net discretionary cash flow can be positive, negative, or equal to zero.

A positive discretionary cash flow indicates that income is greater than savings, taxes, and expenses. This financial situation creates an opportunity for additional savings to accomplish a financial goal, retire debt, or purchase more comprehensive insurance.

A negative net discretionary cash flow is one of the most important weaknesses a financial planner must mitigate against. A negative discretionary cash flow indicates that gross income is less than savings, taxes, and expenses

Question 20

Purpose of a Net Worth Statement

Answer 20

The purpose of the statement of net worth is to explain:

changes in net worth between two balance sheets by reporting financial transactions that are not reported on the income statement or other financial statements.

Example of transactions that would appear on the statement of net worth are:
* Giving or receiving property other than cash
* Inheriting property other than cash
* Employer contributions or matches to retirement savings accounts
* Appreciation or depreciation of assets

Question 21

What is the formula for the statement of net worth?

Answer 21

The formula for the statement of net worth is:

Beginning balance of NW (from the January 1st balance sheet)
+ additions (appreciation of assets, receiving a gift or inheritance)
- subtractions (giving gifts other than cash)
__________________________________________________________________
= Ending balance of net worth (from the December 31st balance sheet)

Question 22

What is The purpose of the cash flow statement ?

Answer 22

The purpose of the cash flow statement is :

to explain how cash and cash equivalents were used or
generated between the period of two balance sheets.

Question 23

The statement of net worth explains changes to net worth such as employer contributions to retirement savings accounts.
a. True b. False

Answer 23

True

Question 24

Define the 6 major categories of a Budget.

Answer 24

The budget will identify spending by major categories and line item income and expenses within those categories. The major categories are:
* Income * Savings * Debt Payments * Living Expenses * Insurance * Taxes

Question 25

What percentage of gross pay should clients budget for living expenses?

Answer 25

Clients should budget 50 percent or less of their gross pay for living expenses.
- Living expenses include all discretionary expenses, plus non-discretionary expenses, and housing costs.
-Discretionary expenses include entertainment, vacations, clothing, cable television, etc.
-Non-discretionary expenses are food, utilities, phone,

Question 26

What percentage of gross pay should clients budget for insurance?

Answer 26

Premiums should be 5-9 percent of gross pay.

The insurance category includes premiums for life, health, disability, home, auto, long term care, and personal liability. Premiums should be 5-9 percent of gross pay.

Question 27

What percentage of gross pay should clients budget for Taxes ?

Answer 27

Clients should budget 20-25 percent of their gross pay for federal, state, and local income taxes, and Social Security.

Question 28

What are the 2 Comparative Financial Statement Tools ?

Answer 28

Vertical analysis and horizontal analysis are two methods of evaluating financial statements over time. The two methods taken together can provide great insight into changes in a person’s (or firm’s) financial situation.

Question 29

Define the Vertical Analysis Financial statement.

Answer 29

Vertical analysis lists each line item on the income statement as a percentage of total income and presents each line item on the statement of financial position (balance sheet) as a percentage of total assets.
The restated percentage is known as a common size income statement or balance sheet. Vertical analysis compares each line item using a common size analysis and strips away the absolute dollar size of the line item.

The benefit of vertical analysis is to gain insight into significant changes from one year to another on a common size basis

Question 30

Define the Horizontal Financial statement

Answer 30

Horizontal analysis lists each item as a percentage of a base year and creates a trend over time.

Question 31

Define Ratio Analysis.

Answer 31

Ratio analysis is the process of calculating key financial ratios for a client, comparing those metrics to industry benchmarks, and then evaluating possible deficiencies.

Beneficial to compare to trends or benchmarks.

Question 32

What the 4 Categories of “ Financial Ratios “ ?

Answer 32

LIQUIDITY RATIOS – Measures the amount of cash and cash equivalents relative to short-term liabilities.
-Emergency Fund Ration
-Current Ratio

DEBT RATIOS – Measures how well client is managing overall debt
- Housing Ratio 1
- Housing Ratio 2
- Debt to Total assets
- Net Worth to Total assets

RATIOS FOR FINANCIAL SECURITY GOALS – Measures progress towards achieving long-term financial security goals.
- Savings Rate
- Investment Assets to Gross Pay

PERFORMANCE RATIOS– Measures return client is generating on assets.
-Return on Investments
- Return on Assets
- Return on Net Worth

Question 33

What is the emergency fund ratio ?

Answer 33

Cash and Cash Equivalents
——————————————————– = Emergency Fund Ratio
Monthly Non-discretionary Cash Flows

of months of non-discretionary expenses the client has in the form of cash and cash equivalents or current assets.

Question 34

What is the Current Ratio ?

Answer 34

Cash and Cash Equivalents
————————————– = Current Ratio
Current Liabilities

Current Ratio The current ratio measures how many times the client can satisfy their short-term liabilities with cash and cash equivalents.

Industry benchmark is 1.0 – 2.0, with the higher the ratio the better

Question 35

Name the 4 Debt Ratios

Answer 35

1. Housing Ratio 1 =< 28
2. Housing Ratio 2 =< 36
3. Debt to Total Assets - should decline as a person ages
4. Net worth to total assets Depends on age 20% for young and higher for older

Question 36

Define Housing Ratio 1

Answer 36

Housing cost (Prin, int, Taxes, Insur) PITI
—————————————————————– = < 28%
Gross pay

Housing ratio 1 (HR1) was established by the banking industry to determine if the relationship between the amount of income and the amount of housing debt that a client is carrying is appropriate and affordable.
- If has a HOA ADD to Housing Cost

Question 37

Define Housing Ratio 2

Answer 37

Housing cost + ALL debt
————————————- =< 36
Gross pay

Housing ratio 2 (HR2) is also referred to as HR1 + all other debt.

This ratio was established by the banking industry to determine if the total amount of debt that a client is carrying is appropriate for their given level of income.

Other debt payments include:
* Car loan payments * Boat loan payments * Student loan payments * Credit cards payments * Principal and interest on vacation or second homes * Any other monthly recurring debt

Question 38

Define debt to total assets Ratio.

Answer 38

T otal Debt
——————– = Benchmark depends on age
Total Assets

Debt-to-Total Assets Ratio indicates the percentage of assets that is owned by creditors.

Lower this ratio the better, = indicates that the assets owned have a low amount of debt owed.

Question 39

Define the Quality of a debt

Answer 39

Quality of Debt The quality of debt assessment is based on the relationship between the term of the debt and the useful life of the asset.

The quality of debt can be classified into three categories:
good, reasonable, and bad debt.

Any time the useful life of the asset far exceeds the term of the debt, the debt is considered good debt. Examples of good debt include a 3-year car loan, a 15-year home mortgage, or student loan debt.

Examples of reasonable debt include a 5-year car loan or a 30-year mortgage

Question 40

define Net worth to total assets Ratio

Answer 40

Net Worth
—————- = Benchmark depends on age
Total Assets

The net worth-to-total assets ratio is the compliment of the debt-to-assets ratio described above.

These two should add up to one.

This ratio provides the planner with the percentage of total assets owned or paid for by the client. It is not surprising that this would be 20 percent for young people and up to 90 to 100 percent for retirement-age clients.

Question 41

What are some of the limitations to the Statement Ratio Analysis :
IE Inflation, etc ?

Answer 41

LIMITATIONS OF FINANCIAL STATEMENT RATIO ANALYSIS
* Inflation
* Difficult to compare financial statements from one period to
the next.
* Use of Estimates
* Any type of net worth calculation includes personal use assets.
* Typically, the value of these assets is only an estimate.
* Benchmarks
* Few benchmarks for personal financial ratios.
* Always important to conduct sensitivity analysis.
* Conduct Monte Carlo Analysis.

Question 42

Define the 2 Ratios for financial security goals

Answer 42

1. Savings Ratio
2. Investment Assets to gross pay

Question 43

Define the Savings Ratio .

Answer 43

Savings + Employer Match (annual)
—————————————————- = benchmark depends on goals
Gross pay (annual ) ( 10-13 startng for 25-35 ages )

Question 44

Define Investment Assets to gross pay

Answer 44

Measures progress towards a client’s saving goal, based on the client’s age and income.
The benchmark (as shown in the following table pg. 217 ) is a useful metric because it provides insight as to:
(1) whether the client has saved enough towards the retirement goal and
(2) how much the client needs in retirement assets to generate a certain level of income at retirement

EX: ( Use table pg 217 )
Income x factor = amount saved for retirement
John age 45 makes $100,000 x 3 = $300,000

At retirement age – 16:1

Question 45

Name the 3 performance ratio’s

Answer 45

-Return on Investments
-Return on Assets
-Return on Net Worth

Provide the planner with information regarding the return the client is earning on assets, net worth, and investments.

Question 46

Define Return on investments (ROI)

Answer 46

I1 - ( I0 + savings)
—————————– = Return on Investments
I0

I0 = Beginning Investments
I1 = Ending Investments
S = Savings (include employer match)

8 – 10% is good

Question 47

Define the Return on Assets (RAO)

Answer 47

A1 - ( A0 + S )
————————— = Return on Assets ( ROA)
A0

A0 = Beginning Assets
A1 =Ending Assets
S = Savings (include employer match

2 – 4% is good

Question 48

Define Return on Net Worth ( RONW)

Answer 48

NW1 - ( NW0 + s)
—————————– = Return on Net Worth
NW0

NW0 = Beginning Net Worth
NW1 = Ending Net Worth
S = Savings (include employer match)

The higher the better. This ratio is likely to become smaller as the
client’s net worth increases.

Question 49

What is a Sensitivity Analysis ?

Answer 49

Process of changing key variables in planning assumptions, to determine the overall impact of those changes on the plan

Sensitivity analysis can also be used to illustrate to the client how the plan would be impacted if the client decides to pursue one or two years of additional work and savings (delayed retirement)

Question 50

What is the Monte Carlo Analysis ?

Answer 50

Monte Carlo analysis is a mathematical simulation to determine the probability of achieving a given outcome. Monte Carlo analysis is useful for financial planners to help measure the probability of certain assumptions being true or false. S

Question 51

Asset formula

Answer 51

Assets = Liabilities + Net Worth
100k 50k 50k

Question 52

Net Worth

Answer 52

New Worth = Assets - Liabilities
50k 100k 50k

Question 53

Liabilities

Answer 53

Liabilities = Assets - Net Worth
50k 100k 50k

Question 54

Define the 2 documents with Financial Statements .

What information does it list ?

Answer 54

Principal Financial Statements:

1. Balance Sheet
   (A Statement of Financial Position or A Statement of Assets, Liabilities and Net Worth)
   - “owns” (assets) and “owed” (liabilities). The difference between assets and liabilities is the owner’s equity = Net Worth
   - Liabilities - reporting debts such as a mortgage or a car loan, only the principal portion of the loan that is due in the next 12 months is reported as a short-term or current liability.
   ______________________________________________________________________
   ASSETS LIABILITIES
   Cash Current Liabilities (paid w/i one yr)
   CD’s Credit cards
   Checking Cars -only Principal $ due in 12 mns
   Home-only Principal $ due in 12 mns
   Outstanding medical expenses
   Insurance premiums due
   Unpaid taxes
   Utility Bills, gas, elec etc.

Investment Assets Long term Liabilities(paid beyond 1 yr)
Home

Personal Use Assets
- Home, Cars, Boats,

Total Assets = Total Liabilities =

                                        Total Assets  -  Total Liabilities   = Net Worth  \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ 2. Statement of Income and Expenses

Question 55

What is the Net Worth formula ?

How do you value Assets ?

How do you value Liabilities ?

Answer 55

Net worth = ASSETS - LIABILITIES

Assets are listed at “ Fair Market Value “

Liabilities listed as “ Outstanding Balance “

Question 56

What is the impact on Net Worth with the following ?

• down payment,

EXAMPLE :
Josephine buys a house for $400,000. She makes a $50,000 down payment and finances the balance with a mortgage. How is her net worth impacted from this transaction?

Answer 56

Josephine buys a house for $400,000. She makes a $50,000 down payment and finances the balance with a mortgage. How is her net worth impacted from this transaction?

                                  ASSETS    -      LIABILITIES      =     NET WORTH  CASH                           - 50,000                                                 -50,000 Personal Assets      + 400,000                                              +400,000 Mortgage                                             -350,000                    - 350,000 \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ Net impact              + 350,000           -350,000                                  0

Question 57

What is the impact on Net Worth with the following ?

• Reduced outstanding debt and home value increased

EXAMPLE:
One year ago, Elaine purchased a house for $400,000. Today, the house is worth $425,000 and she has reduced her outstanding mortgage principal by $10,000. What is the impact to Elaine’s net worth?

Answer 57

One year ago, Elaine purchased a house for $400,000. Today, the house is worth $425,000 and she has reduced her outstanding mortgage principal by $10,000. What is the impact to Elaine’s net worth?

                                  ASSETS    -      LIABILITIES      =     NET WORTH  CASH                                                                                          Personal Assets      + 25,000                                                 +25,000 Mortgage                                             +10,000                      +10,000 \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ Net impact              + 25,000             +10,000                       +35,000

Elaine’s net worth increased as a result of the value of her house increasing ($25,000), plus she has paid down her mortgage throughout the year. Since her liabilities have decreased by $10,000, the two actions result in Elaine’s net worth increasing by $35,000.

Question 58

Statement of Income and Expenses

Answer 58

Statement of Income and Expenses

CASH INFLOWS

SALARY
Salary - Husband
Salary - Wife
TOTAL INFLOWS = _________________
___________________________________________________
CASH OUTFLOWS ( S D L I T )
S AVINGS
Husband’s 401(k) Plan
Wife’s 401(k) Plan
IRA Contribution
Education Savings (529 Plan)
TOTAL SAVINGS = __________________

D EBT Payments
Personal Residence
Auto -
TOTAL DEBT PAYMENTS = = _____________________

L IVING EXPENSES
Utilities
Gasoline for Autos
TOTAL LIVING EXPENSES = = _____________________

I NSURANCE Payments
HO Personal Residence
Auto Premiums
TOTAL INSURANCE PAYMENTS = =______________________

T AXES
Federal Income Taxes Withheld
State Income Taxes Withheld
Social Security Taxes
Property Tax Personal Residence
TOTAL TAXES = = ______________________

Total Savings, Expenses and Taxes =__________________________________

NET DISCRETIONARY CASH FLOW = __________________________________

Question 59

Impact on net worth examples:

1. Buy a Car: 40k , $5k down, finance 35k

2.,Buy furniture $10k, $5k down finance 5K

3. Portfolio performance will increase or decrease Net Worth ?

Answer 59

1. Assets - Liabilities = Net worth
   cash -5,000 -5,000
   personal 40,000 40,000
   Loan - 35,000 -35,000
   ————————————————————————–
   no impact on net worth = 0
2. Assets - Liabilities = Net worth
   cash -5,000 -5,000
   personal 10,000 10,000
   Loan -5,000 - 5,000
   ————————————————————————–
   no impact on net worth = 0
3. YES

Question 60

What is the formula for Assets ,

if you know liabilities and net worth ?

Answer 60

Liabilities + Net worth = Assets

Question 61

John and Jane have a net worth of $20,000 and total assets of $150,000. If their revolving credit and unpaid bills total $8,000, how much are their total liabilities?

A. $122,000
B. $130,000
C. $138,000
D. $150,000

Answer 61

B. $130,000

A - L = Net worth

$150,000 - L = $ 20,000