Financial Statements and Cash Flow

Question 1

Net Worth

Answer 1

Net Worth = Assets – Liabilities
Assets = Liabilities + Net worth
Liabilities = Net worth - Assets

Question 2

Cash/cash equivalents

Answer 2

• cash
• savings accounts
• checking accounts
• CDs close to maturity
• money market deposit account (bank) * Laddered CDs
• money market mutual fund (security)

Question 3

Investments

Answer 3

• variable and fixed annuities
• pensions, IRAs, Roth IRAs
• business interests
• mutual funds
• real estate owned for investment purposes
• stocks/bonds
• collectibles owned for investment purposes
  Note: Life insurance cash values are technically not cash equivalents because life insurance companies may delay distributing such funds for up to 6 months (delay clause).

Question 4

Use assets

Answer 4

• home
• vacation home
• personal property
• automobiles or recreational vehicles
• collectibles for personal enjoyment
  Note: Assets are generally shown at fair market value. Fair Market Value (FMV) reflects what buyers
  are willing to accept presuming neither is forced into the transaction

Question 5

Liabilities

Answer 5

*credit card balance(s) * auto loan balances
* personal loans

Question 6

Statement of Financial Position (Balance Sheet)

Answer 6

Net Worth Statement
- Assets value and liabilities value

Question 7

Statement of Cash Flow

Answer 7

When a question asks the amount of clients’ savings, assume that any funds not allocated to expenses
will be savings (Inflows − Outflows = Savings).
- Inflows and Outflows

Question 8

Inflows (same as gross income)

Answer 8

• Salary(ies)
• Interest and dividend income
• Capital gains
• Alimony received
• Rental income
• Social Security benefits
• Trust fund income
• Child support
• Inheritance
• Gifts

Question 9

Fixed outflows (little to no flexibility)

Answer 9

• Note payments / car payments
• Mortgage payments, rent
• Insurance premiums (life, health)
• Property tax
• Alimony paid

Question 10

Variable outflows (some flexibility)

Answer 10

*Food
* Car maintenance
* Clothes
* Utilities
* Entertainment
* Vacation
* Gifts
* Charity
* Home maintenance
* Miscellaneous

Question 11

Taxes

Answer 11

• Income taxes (federal and state)
• FICA taxes and self-employment taxes

Question 12

The relationship between the balance sheet and the cash flow statement

Answer 12

If the cash flow statement indicates a cash surplus in the current period. This will increase the net worth amount by the same.
- Because the savings is coming from cash flow (new money in), their net worth would increase by this amount

Question 13

Business financial statements

Answer 13

The balance sheet, income statement, and statement of cash flow can be used to valuate a business

Question 13

Book value

Answer 13

Book value reflects the corporate balance sheet. The book value of assets minus the book value of
liabilities is the net worth of the business.

Question 14

Capitalization of income

Answer 14

The projected flow of income from a business can be converted into a present value amount. The formula for capitalized value is as follows (not provided on formula sheet):
Capitalized Value =
Annual Income/
Capitalization Rate

Question 15

Capitalized Value

Answer 15

Annual Income/
Capitalization Rate

Question 16

Pro forma statement

Answer 16

A pro forma statement projects the expected profitability or return of the next year or longer (the future).
It estimates the excess of income over expenses. It allows the owner of the business to plan investment
or spending of the projected excess. At year end the actual financial statements can be compared with
the pro forma statement to see if the financial projections were realized. Ethical conduct requires a
disclaimer indicating that proforma projections may or may not be achieved.

Question 17

Budgeting

Answer 17

Budgeting estimates the amount of money to be received and spent for various purposes within a given time frame. Many people may not record income and spending activity. Budgets make clients feel constrained.

Question 18

How long a period should a typical family budget cover?

Answer 18

Twelve months is typical, but shorter time periods can be used if annual income and expenses cannot be estimated
* Make it flexible
* Make it simple
* Keep it long enough – typically 1 year
* Estimate unknowns
* Modify a sample budget to fit the client * Estimate variables

Question 19

Emergency fund

Answer 19

The emergency fund should be invested in the following vehicles with high accessibility and minimal
principal fluctuation including:
* checking accounts (excluding funds to be utilized for necessary expenses*)
* government money market accounts
* savings accounts
* CDs if close to maturity ≤ 90 days
* laddered CDs ≤ 6 months

Question 20

Emergency Fund Calculation Note

Answer 20

*If the current checking account balance exceeds the normal monthly expenses, subtract one month of
expenses. If the normal monthly expenses exceed the funds in the checking account, ignore the negative number. For example, if normal monthly expenses are $8,000 and the clients only have $6,000 in their checking account, then the checking account balance can’t be allocated for the emergency fund.
However, don’t subtract $2,000.

Question 21

The amount needed is 3-6 months of fixed and variable expenses and real estate taxes if

Answer 21

Use 3 months if
* Single with second source of income
* Married, both work and have similar wages
* Married, only one spouse works but has
second source of income
… Use 6 months if…
* Single wage earner
* Married, only one spouse works

Question 22

What are generally considered to be second sources of income?

Answer 22

One party receives alimony
* One party is significantly wealthy
* One party has a large trust fund providing income and rights of withdrawal of principal

Question 23

Debt management ratios

Answer 23

Housing expenses: (PITI* or rent) should reflect ≤ 28% of gross income (most tested)
Total monthly debt: should reflect ≤ 36% of gross income (maybe tested)
Consumer debt: should reflect ≤ 20% of net income (probably not tested)
* PITI stands for Principal, Interest, Taxes (property only), and Insurance (homeowners only)
Housing expense is the most important ratio. Total monthly debt includes housing expense, auto loans,
credit card debt, etc.

Question 24

Liquidity/current ratio

Answer 24

Current Assets / Current Liabilities
Current assets:
* cash equivalents
* marketable securities
* accounts receivable
* inventory
Current liabilities:
* cash owed
* accounts payable
* credit card debt
* taxes payable
Note: Use credit card debt even if the credit cards are paid off monthly. Only use taxes payable when
the material indicates the taxes are due or the material actually says the taxes are payable. Only
use mortgage information when the data tells you the “current amount” of the mortgage due

Question 25

Saving Strategies

Answer 25

The ideal level of savings will depend on a particular client’s employment outlook, budget constraints,
taxes, etc. Savings represents the excess of cash inflows over cash outflows after taxes. Ideally, a
family should save at least 5-8% of gross income.