Fundamentals/Financial Statements and Analysis

Question 1

Q1: What are the primary Personal Financial Statements?

Q2: What is the presentation of the statement related to Net Worth?

Answer 1

A1: Balance Sheet (Statement of Financial Position or Net Worth Statement), Income and Expense Statement (Statement of Cash Flows)

A2:

Cash & Cash Equivalents Liabilities

Invested Assets

Personal Use Assets Net Worth

Question 2

Q1: What are the categories of ASSETS on the Balance Sheet?

Q2: Describe each

Answer 2

A1: Cash & Cash Equivalents, Invested Assets, Personal Use Assets

A2:

• Cash & Cash Equivalents: (aka Current Assets); cash, checking, money market, CDs less than 12 months, CD ladder set to mature every 6 months
  
  • Everthing client can convert to cash in 1 year
  • DOES NOT include EE savings bonds
• Invested Assets: assets with greater than 12 month maturity
• Personal Use Assets: anything to maintain client’s lifestyle

Question 3

Q1: How are liabilities stated on the Balance Sheet?

Q2: How are they classified? Examples?

Q3: What is Net Worth?

Answer 3

A1: Principal outstanding

A2:

• Current and Long-term
  
  • Current - due within next 12 months and excludes interest unless already incurred
  • Long-Term - greater than 12 months

A3: Net Worth = Assets - Liabilities

Question 4

What are some limitations on the usefulness of the balance sheet?

Answer 4

• Why/how an asset increased in value
• Whether client bought more of an asset or did it appreciate?
• Why/how an asset or liability appears on the Balance Sheet
• If the client purchased or inherited an asset
• Does not explain changes in Net Worth
• Whether increase in Net Worth due to increased savings, inherited assets, appreciation of assets or debt retirement

Question 5

Q1: What is included on a Statement of Income and Expenses (Statement of Cash Flows)?

Q2: What are the limitations?

Answer 5

A1: A listing of income, savings, expenses and taxes

A2:

• Does not consider employer’s contributions to retirement plans, only EE contributions to savings account
• Does not capture/report giving or receiving of gifts or inheritances

Question 6

Q1: What is Financial Statement Analysis?

Q2: What is a limitation?

Answer 6

A1: Gives insight to a client’s strengths and weaknesses

• Answers questions
  
  • How well client manages debt
  • How well client is progressing towards financial goals
  • How well client is able to meet short-term obligations

A2: Only a historical perspective, not predictive of the future

Question 7

Q1: What is the type of expense used in Emergency Fund? How much does a client need?

Q2: Describe the type of expense used

Q3: So what isn’t included?

Q4: What is the formula for Emergency Fund?

Answer 7

A1: Non-discretionary expenses; 3-6 months

A2: only the expenses that do not go away if you lose your job

A3: Income taxes, payroll taxes, contributions to retirement savings account

A4: Emergency Fund = Current Assets / Monthly Non-discretionary expenses

Question 8

What are the debt ratios?

Answer 8

• Consumer Debt Payments: less than 20% of NET INCOME
• Housing Debt Payments: less than/equal to 28% of GROSS INCOME
• Housing and All Other Recurring Debt: less than/equal to 36% of GROSS INCOME

NOTE: Do not subtract taxes or savings when calculating 28 or 36 ratios, formula requires GROSS INCOME

Question 9

Q1: What is the formula for the Housing Ratio?

Q2: what is the formula for Housing and All Other Debt Ratio?

Answer 9

A1: monthly housing costs (PITI) / monthly gross income; ratio should be 28% or less

Principal

Interest

Taxes (property)

Insurance (Homeowners)

A2: monthly housing costs (PITI) + all other recurring debt payments / monthly gross income; ratio should be 36% or less

Question 10

$250,000 Mortgage, 30 years, 6% interest, first payment July 1

Q1: What is the monthly payment?

Q2: What is the interest deduction in year 1?

Q3: What is the principal balance at the end of year 1?

Answer 10

A1: PMT = 1498.88

A2: 7481.21 (1 INPUT 6 SHIFT AMORT ==)

A3: 248487.93

(payments X number of months) - interest = mortgage reduction

(1498.88 X 6) - 7481.21 = 1512.07

250000 - 1512.07 = 248487.93

Question 11

Q1: What are the performance ratios?

Q2: What are the benchmarks?

Answer 11

A1:

Savings Ratio: Annual Savings (EE + ER Contributions) / AGI

ROI: (Ending Investments - Beginning Investments - Savings - Gifts Received) / Average Invested Assets*

_*Average Invested Assets_ = (Beginning Investments + Ending Investments) / 2

A2:

Savings Ratio: 10-12% of Gross Income if savings stats before age 32; 20-25% age 45 or 50; important to include ER contributions in calculation

ROI: based on client’s age and risk tolerance

Question 12

What are the limitations of Financial Ratio Analysis?

Answer 12

Inflation: difficult to compare one period to the next

Use of Estimates: Any type of Net Worth calculation includes personal use assets which are stated at an “estimated fair market value”

Benchmarks: very few for personal financial ratios and only serve as a rule of thumb, individual circumstances may case benchmarks to be irrelavent.

(Ex. Gates son and 10 -12% savings ratio)