Chapter 4 - Assessing the Client's Financial Situation

Question 1

What is the net worth? What does it show?

Answer 1

• Put simply, net worth is the difference between the total assets and total liabilities of an individual, family unit, or business.
• For an individual or family, net worth is the basic measure of financial health.

Question 2

Why involved yourself in net worth planning? (4)

Answer 2

• The purpose of net worth planning is fourfold:
• It helps to establish financial discipline.
• It sets out a strategy to achieve a future financial target.
• It provides a means to measure financial progress at regular intervals.
• It provides reassurance about future financial security

Question 3

Calculating net worth. What count as assets? what count as liabilities?

Answer 3

ASSETS:
may include a house, cottage, savings accounts, mutual funds, plus stocks and bonds.

Liabilities:
may include a mortgage, credit card balances, and other loans.

Question 4

What financial records are needed to create a net worth statement? (A LOT OF THINGS)

Answer 4

• Recent tax returns * Bank statements * Cancelled (i.e., paid) cheques * Credit card information * Itemized living expenses * Brokerage account and mutual fund records * Mortgage payments * Real estate closing records * Life insurance policies * Disability insurance coverage * Property insurance policies indicating fair market value (or replacement cost) of personal property * Pension account records * Loan repayment schedules for automobile and other big-ticket items purchased on credit

Question 5

What four features do net worth statements have in common?

Answer 5

• Assets are categorized as liquid, investment, or personal assets.
• Investment assets are further classified as short-term and long-term.
• Long-term assets are further classified as equity, fixed income, or miscellaneous assets.
• Liabilities are categorized as short-term or long-term

Question 6

How can we use the net worth statement in our planning strategy?

Answer 6

The net worth amount provides the basis for developing an appropriate net worth planning strategy involving a target growth rate. The net worth amount at the end of a given year (or on any other date) should be compared with the amount on the same date of the previous year.

• If the annual rate of growth meets the target rate, the client may choose to maintain the existing growth rate or devise improved strategies to accelerate growth.
• If the current rate of growth falls short of the target rate, the client must either develop new strategies to correct the situation or set a more realistic net worth goal.
• If net worth has declined, the client may have to revise some goals and develop more aggressive strategies to reduce debt, reduce expenses, increase income, and increase investment return.

Question 7

What is a cash flow statement?

Answer 7

• A cash flow statement, on the other hand, shows how much money flows in and out of a household or business over a set period (generally not exceeding one year).

Question 8

What is a primary way your net worth can grow?

Answer 8

• One of the primary ways net worth can grow is through positive net cash flow or savings. Net worth also increases if asset values rise while liabilities decline.

Question 9

How can we positively affect our net cash flows?

Answer 9

The two options are to reduce spending or increase income

Question 10

(1) Reducing expenses. What do we need to look at? What are the two kinds of expenses?

Answer 10

• Clients who opt to reduce expenses must first carefully analyze their current expenses.

discretionary expenses – Flexible expenses that can be reduced without seriously affecting the desired lifestyle. These types of expenses may include clothing, personal care, and entertainment. In some cases, clothing and basic appliances are not entirely discretionary, but the amount one chooses to spend on these items may be flexible.

non-discretionary expenses. – - Fixed expenses that may affect the desired lifestyle if reduced. These items may require more effort to reduce without a serious impact on basic comfort or lifestyle. For example, lowering non-discretionary expenses may require moving to a different neighborhood or a smaller home.

Question 11

(1) what are two other ways to reduce debt?

Answer 11

• Other ways to reduce expenses are through current expense control and debt restructuring, which are described below

Current expense control
* This method requires some restraint in spending on largely discretionary expenses. The ultimate objective is to institute a workable, long-term plan of expenditure control.

Debt restructuring
* Debt restructuring may take several forms, including the following measures:
* Consolidate multiple high-interest credit card balances into one low-interest personal loan or line of credit.
* Refinance the personal residence.
* Discontinue the use of credit cards.
* Defer the purchase of big-ticket items.

Question 12

(2) Increasing income. What are the options?

Answer 12

• Clients should consider the following options to increase their income (although not all options are realistic for all clients):
• Work extra hours or do some consulting work.
• Negotiate a salary increase.
• Take a higher paying job.
• Expand a business.
• Change the asset allocation to increase investment income.

Question 13

(2) - To increase income by changing asset allocation, consider the following strategies: (5 ways)

Answer 13

• Switch to investments that offer the highest consistent returns at a risk level acceptable to the investor.
• Reduce the chequing account balance to the minimum, then shift the rest of the liquid funds into higher yielding money market funds and premium savings accounts.
• Move funds from low-risk investments into investments in the highest-risk categories acceptable to the client (e.g., from GICs to balanced mutual funds).
• Convert a growth-oriented stock portfolio into either an income-oriented stock portfolio or a bond portfolio, thereby swapping potential capital gain for more income.
• Reposition assets (to increase cash flow) as follows: Postpone the purchase of non-essential consumer items, such as a boat or luxury car. Dispose of negative cash flow properties (such as leveraged real estate and limited partnerships requiring long-term periodic payments). Move non-income-producing investments, like gold, art, coins, and antiques, into income-producing assets

Question 14

What is the starting point of cash management?

Answer 14

he starting point of cash management planning is the preparation of a cash flow statement.

Question 15

What is a cash flow statement? Why is it important? WHat is the first objective of cash flow management?

Answer 15

A current cash flow statement shows cash inflows and outflows for the past year. A projected cash flow statement is an estimate of future cash inflows and outflows.

The first objective of cash flow management is to ensure that sufficient funds are available for savings and investments.

Prudent management of funds is required if clients are to achieve their prioritized financial goals and increase their net worth over the long term.

Question 16

What is an investment strategy that can help refine your net worth target?

Answer 16

For better results, you can further refine the net worth growth target by setting up separate streams of funds for investment, children’s post-secondary education, and retirement. By earmarking adequate funds for specific goals, you can help clients create a more efficient system for achieving them.

Question 17

In fact, preparing a monthly budget is only a means toward achieving a much broader, and far more valuable, objective. Then what is the key to long-term financial success? What are the two ways this plan can be used?

Answer 17

The key to long-range financial success is the development of a systematic savings plan.

• To generate the necessary savings to achieve set goals
• To systematically direct these savings toward targeted areas to achieve specific financial goals

Question 18

What is a projected cash flow statement? How can we make it optimal? How is it helpful?

Answer 18

A client’s projected cash flow statement is a planning tool that forecasts the amounts and the timing of the client’s cash inflows and cash outflows for a specified period, usually one year. The projected cash flow statement, which is based on a client’s current cash flow statement, provides a comprehensive forecast of future income and expenses.

To develop a realistic and workable projected cash flow statement, clients must understand the financial trade-offs required. In other words, they must decide to what extent they are prepared to adjust their current lifestyle so that they may achieve their financial objectives.
A projected cash flow statement is a vital financial planning tool that helps you determine whether your recommendations are both realistic and feasible

Question 19

What are the three ways a projected cash flow statement can be used as a planning tool to help clients? What do the three ways mean?

Answer 19

a. Control spending
* Clients can gain control of their spending if they keep careful track of their expenses. They must also compare those expenses to the projected cash flow statement and continually adjust their spending accordingly.

b. Ensure liquidity
* The projected cash flow statement can help to ensure that clients can meet their current expenses without borrowing.

c. Implement the financial plan
* The projected cash flow statement should integrate the financial planner’s key recommendations relating to all of the financial planning elements. With this tool, clients should feel confident that they can implement a workable financial plan

Question 20

WHat is the first stage of a savings plan?

Answer 20

Goal setting

Question 21

What is the second stage in a savings plan?

Answer 21

The next step is to calculate the amount of savings required to achieve each of the specific goals and record them in the last column.

Question 22

What is the most effective savings strategy?

Answer 22

A practical strategy is to treat savings as a fixed, non-discretionary expense, rather than an amount left over after all other needs have been met. This strategy can help to prevent shortfalls in cash flow and generate additional savings. If properly channeled, those savings can accelerate the growth rate of net worth.

Question 23

What are four other savings strategies? WHat do they entail?

Answer 23

B1. Set realistic goals
* Unrealistic goal-setting is perhaps the most common reason why savings plans fail. The best rule is to start with a small savings goal the client can easily meet. After some time, the goal can be increased. Once the client becomes accustomed to the new expenditure and savings level, the goal can be increased.

B2. Set up an automatic savings plan
* A relatively painless but effective way to save is to arrange for an automatic deduction of money from a paycheck or bank account, which is then deposited in an appropriate savings vehicle. A good amount to consider is 10% of the client’s net pay.

B3. Resisting buying on credit
* We live in a consumption-oriented society, where it is extremely easy to buy on credit. Few of us realize that our savings rate would dramatically increase if we avoided buying items on credit.

B4. Reward yourself
* The reward can be an incentive for the family to work to meet a savings goal

Question 24

Why is it important to have an emergency fund?

Answer 24

• Occasionally, even the best-structured budgetary plans can face temporary difficulties due to circumstances beyond a client’s control. For this reason, it is important that the client have liquid fund reserves set aside for emergencies.

Question 25

What are some appropriate investment vehicles for an emergency fund? What are their characteristics?

Answer 25

Appropriate vehicles for an emergency fund are savings accounts, cashable GICs, and money market securities.

Investments of this type are easily cashable and do not fluctuate in value with changes in interest rates or the stock market and are liquid.

Question 26

If a client does not want to receive the low returns that a GIC or MM fund will give you, what is an option?

Answer 26

In such cases, you can recommend that they set up a line of credit with their financial institution.

Question 27

If a client has not had time to build up an adequate emergency fund, or if the initial emergency funds are exhausted, what other sources of funds can be used?

Answer 27

1. Home equity loan
   * A home equity loan is a loan advanced against the equity built up in a principal residence. Clients should apply for such a loan before the need arises to use it.
2. Life insurance
   * Part of the premium paid on a permanent life insurance policy is set aside in a policy reserve (or cash value), which can be withdrawn upon surrendering the policy. Clients may also borrow against the accumulated cash value or policy loan value of the reserve.
3. RRSP
   * Withdrawing RRSP savings is the least advisable option because of the negative long term impact on a client’s retirement assets and lifestyle. When funds are withdrawn, the institution holding the RRSP is required to deduct a withholding tax for federal purposes. The initial amount withheld is 10% to 30% of the amount withdrawn (20% to 30% for Quebec). When the client files an income tax return, the taxes payable may increase or decrease, depending on the client’s income for the year. Higher taxes can result because the entire amount withdrawn from an RRSP must be brought into income in that year and becomes taxable. A large withdrawal from an RRSP can also push the client into a higher tax bracket. Cannot be used unless for specific programs like home buyers plan or lifelong learning program.

Question 28

What is the time value of money (TVM)?

Answer 28

means that a dollar held or received today is worth more than a dollar received at a later date, given that today’s dollars can be invested to generate some type of return. This concept is especially important to wealth managers, who must attempt to estimate, calculate, and match various cash flows for years into the future.

Question 29

All TVM calculations involve solving for one of five variables:

Answer 29

N = The number of years or compounding periods
I/Y = The annual or periodic interest rate, discount rate, or rate of return
PV = The present value of the asset or liability
PMT = The periodic payments required, if any
FV = The future value of the asset or liability

• The goal of all TVM calculations is to solve for one of these five variables, given values for the other four.

Question 30

What are the 5 problems involving time value of money?

Answer 30

• Future value of a single amount
• Future value of an annuity
• Present value of a single amount
• Present value of an annuity
• Solving for time periods, interest rates, and payments

Question 31

1. FUTURE VALUE OF A PRESENT AND SINGLE AMOUNT

Answer 31

• The money you have today is worth more than the money you will receive in the future because of the interest you can earn by putting that money in a savings account or investing it in other securities. This concept becomes even more important when you introduce compound interest, where the interest earned starts earning interest itself.
• Another consequence may be that the quoted annual interest rate is different from the effective annual interest rate, which is the actual interest rate earned. The difference can be significant. For example, the effective annual interest rate on some credit cards is usually much greater than the quoted rate because the quoted rate is combined with daily compounding.

Question 32

2. FUTURE VALUE OF AN ANNUITY

Answer 32

• The future value of an annuity (i.e., an equal, annual series of cash flows) answers the question, “How much money would I have after a given number of years if I were to invest a certain amount regularly?” The future value of an annuity is based on regular, equal deposits or investments at the end or at the beginning of each period for a certain number of periods while allowing those cash flows to grow.

Question 33

3. PRESENT VALUE OF A SINGLE AMOUNT

Answer 33

• Think of present value as future value in reverse. For example, assume you already know the future value of your investment and want to know what your starting principal will have to be to reach that amount in the desired length of time. In other words, present value is the value in today’s dollars assigned to an amount of money in the future based on some estimated rate of return over the long-term.

Question 34

4. PRESENT VALUE OF AN ANNUITY

Answer 34

• Knowing the present value of an annuity (or other series of cash flows) allows you to calculate the value today of an annuity in the future. In other words, if you were to invest $100 a month for the next five years, what would the total amount be worth in today’s dollars? Again, remember that an annuity is based on regular, equal deposits or investments at the end or beginning of each period for a certain number of periods.

Question 35

5. SOLVING FOR TIME PERIODS, INTEREST RATES, AND PAYMENTS

Answer 35

• The previous four operations are focused on finding present and future values. However, as an advisor, you may be presented with a situation in which you know the present and future values and must find another value. You may need to determine the payments, the interest rate, or the number of time periods it will take for the present value to grow to the future value.