Chapter 3 Homework Flashcards
Housing Ratio 1 (HR1)
This ratio reflects the proportion of gross pay on an annual or monthly basis that is devoted to housing (principal, interest, taxes, and insurance). It does not include utilities, lawn car, maintenance, etc. The benchmark for housing ratio 1 is less than or equal to 28 percent.
Housing Ratio 2 (HR2)
This ratio combines basic housing costs (principal, interest, taxes, and insurance) with all other monthly debt payments, including automobile loans, student loans, bank loans, revolving consumer loans, credit card payments, and any other debt payments made on a recurring basis. The benchmark for housing ratio 2 should be less than or equal to 36 percent of gross pay on a monthly or annual basis.
Investment Asset to Gross Pay Ratio
This ratio assesses a retirement plan that persistently has clients save 10-13 percent of gross pay for retirement
Life Cycle Approach
This approach provides the planner with a brief overview of the client’s financial profile which permits the planner to have a relatively focused conversation with the client. it is used very early in the engagement.
Liquidity Ratios
These ratio measure the ability to meet short-term obligations.
Metrics Approach
This approach uses qualitative benchmarks for a measurement of where a client(s) financial profile should be. When combined with the two-step/three-panel approach, metrics help establish objectives that are measurable compared to ratio analysis.
Net Worth to Total Assets Ratio
This ratio provides the planner with the percentage of total assets owned or paid for by the client.
Non-discretionary Cash Flows
Mostly fixed expenses which are required to be met monthly or annually regardless of loss of income.
Performance Ratios
These ratios determine the adequacy of returns on investments, given the risks taken.
Pie Chart Approach
This approach is a visual presentation of how the client spends money. It provides a broad perspective on the client’s financial status and it is generally used after the collection of internal data and the preparation of financial statements.
Present Value of Goals Approach
This approach considers each short-term, intermediate-term, and long-term goal, determines their respective present value, then sums all of these together and treats the sum as an obligation (liability) that is then reduced by current resources of investment assets and cash and cash equivalents.
Ratios for Financial Security Goals
These ratios asses the progress that the client is making towards achieving long term financial security goals.
Return on Assets (ROA) Ratio
This ratio calculates the return on investment assets.
Return on Investments (ROI) Ratio
This ratio calculated the rate of return on investment assets.
Risk management
Recommendations usually are related to the insurance portfolio because perils (the cause of a loss) are event driven (e.g., untimely death) or unpredictable, and can occur at any time.
Savings and Investing Management
Management that results in recommendations that require both an increase in savings and an increase in the emergency fund. The savings rate (savings and reinvestment of dividends, interest, and capital gains, plus an employer match/gross pay) should equal 10-13 percent if the client only has one goal, that being financial security. If the client and family have multiple goals including retirement, college education, and lump-sum goals (e.g., new house or second home) the savings rate must be increased.
Savings Rate
A rate calculated by taking gross savings in dollars (including employee elective defferals in 401(k), 403(b), and 457 plans plus any employer match), and any other savings dividends by gross pay.
Strategic Approach
This approach uses a mission, goal, and objective approach considering the internal and external environment and may be used with other approaches.
Two-step/ Three-panel Approach
A step-by-step approach where the client’s actual financial situation is compared against benchmark criteria. It stresses the management of risk, seeks to avoid financial dependence, and promotes savings and investing to achieve financial independence
List and define the eight approaches to financial planning analysis and recommendations.
- The life cycle approach is used early in the financial planning engagement and is a brief overview of the client’s financial profile allowing the financial planner to have a focused conversation based on the profile.
- The pie chart approach is a pictorial representation of the client’s financial profile based on the client’s balance sheet and statement of income and expenses.
- The financial statement and ratio analysis approach uses ratios derived from the client’s financial statements that are then compared to benchmark metrics for an evaluation of strengths, weaknesses, and deficiencies.
- The two-step/three-panel approach stresses the management of risk and promotes financial independence through savings and investing.
• The present value of goals approach determines the present value of each of the short-term, intermediate-
term, and long-term goals and compares the sum to the currently available resources. This comparison will
generally yield a deficit that can be amortized over the work life expectancy and compared to the current
savings amount. If the deficit amount is in excess of the current savings then the savings needs to be
increased.
- The metrics approach uses benchmarks for measurement of where a client’s financial profile should be as compared to the client actual.
- The cash flow approach analyzes the income statement to evaluate and prioritize the “purchase” of financial planning recommendations driving down the discretionary cash flow.
• The strategic approach is a mission, goal, and objective driven financial plan that considers a client’s needs
versus wants and is usually used in conjunction with other financial planning approaches.
List the three phases of the life cycle approach.
• The asset accumulation phase usually occurs in the early 20s to late 50s when cash flow for investing is low
and debt to net worth is high.
• The conservation/risk management phase occurs from late 20s to early 70s where cash flow and net worth
have increased and debt has decreased somewhat. Risk management of life events like employment, disability, and untimely death become a priority.
• The distribution/gifting phase is from late 40s to end of life and usually is characterized by high additional
cash flow, low debt, and high net worth.
What are some of the questions that an income statement pie chart will answer?
- How much is the client paying in taxes as a percentage of gross pay?
- What percentage of gross pay is going toward savings?
- What portion of gross pay is spent on insurance (risk management)?
- How much is spent on basic housing costs (and other debt)?
- What portion of the client’s gross pay is left for discretionary spending?
What are some of the questions that a balance sheet pie chart will answer?
What percentage of total assets is:
- cash and cash equivalents,
- investment assets,
- personal use assets,
- current liabilities,
- long-term liabilities, and
- net worth?
What is an advantage to using the pie chart approach with clients?
The pie charts are effective for assisting client’s to visualize their financial situation including where their assets are deployed in cash, for long term goals, or for maintaining their current lifestyle.
