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CFP NOV 2024 Prep > Financial Fundamentals - Ch 3 > Flashcards

Financial Fundamentals - Ch 3 Flashcards

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1
Q

Define the 7 steps to the Financial Planning Process.

A
  1. Understanding the clients personal and financial circumstances
  2. Identifying and selecting Goals
  3. Analyzing the clients current course of action and potential alternatives
  4. Developing the financial planning recommendation
  5. Presenting
  6. Implementing
  7. Monitoring

U I A D P I M

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2
Q

What is the life cycle approach to financial planning analysis and recommendations- ?

A

The life cycle approach - Data collection is quick, simple, and relatively nonthreatening to the client.

  • Provides brief overview of the client’s financial profile permitting the planner to have a relatively focused initial conversation with the client. It is generally used very early in the engagement and is generally high level as opposed to detailed.

-For preliminary stages of a financial planning engagement to get a general idea of the financial situation of the client and/or to present, in the case of the pie chart approach, a graphical picture of the current and general benchmark situation

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3
Q

What is the “ Pie chart” approach to financial planning analysis and recommendations- ?

A

The “pie chart” approach:

  • VISUAL representation of how the client allocates financial resources.
  • 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.
  • For PRELIMINARY STAGES of a financial planning engagement to get a general idea of the financial situation of the client and/or to present, in the case of the pie chart approach, a graphical picture of the current and general benchmark situation
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4
Q

What is the The financial statement and ratio analysis approach to financial planning analysis and recommendations- ??

A

Establish a financial snapshot of the client as of today. The ratio analysis provides an opportunity to assess the client’s strengths, weaknesses, and deficiencies by comparing the client’s ratios to the benchmark metrics

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5
Q

Identify the 8 approaches to financial planning analysis and recommendations ?

A
  1. Life cycle approach
  2. Pie Chart
  3. Financial statement and ratio analysis approach
  4. two and 3 panel approach
  5. present value of goals approach
  6. metric approach
  7. cash flow approach
  8. strategic approach
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6
Q

What is the two and three panel approach to financial planning analysis and recommendations ?

A

A step-by-step approach in which the client’s actual financial situation is compared against benchmark criteria. This approach is relatively
thorough and presents a manageable
approach to the client. It stresses the management of risk, seeks to avoid financial dependence, and promotes savings and investing to achieve financial independence.

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7
Q

What is the metrics approach to financial planning analysis and recommendations- ?

A

Uses quantitative benchmarks that provide rules of thumb 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 dollar and percentage measurable compared to ratio analysis.

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8
Q

What is the cash flow approach to financial planning analysis and recommendations- ?

A

The cash flow approach - This approach takes an income statement approach to
recommendations. It uses the three-panel approach and uses a pro forma approach (as if) “to purchase” the suggested recommendations. This approach has the effect of driving down the discretionary cash flow. Next, positive cash flows or the sale of assets are identified and used to finance the recommendations

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9
Q

What is the strategic approach to financial planning analysis and recommendations- ?

A

The strategic approach - This approach uses a mission, goal, and objective approach considering the internal and external environment and may be used with other approaches

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10
Q

What are the 3 phases of the life cycle approach ?

A
  • The asset accumulation phase usually begins in the early 20s and lasts to mid 50s when discretionary cash flow for investing is low and the debt-to-net worth ratio is high.
  • The conservation (risk management) phase usually begins in the late 20s and lasts to the early 70s, where cash flow, assets, and net worth have increased and debts have decreased somewhat. In addition, risk management of events like unemployment, disability due to illness or accident, and untimely death become a priority.
  • The distribution (gifting) phase usually begins in the mid 40s or early 50s and continues to the end of life. It is characterized by the individual having high cash flow, low debt, and high net worth.
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11
Q

What are the Income Statement Targeted Example Benchmarks ?

Taxes (income and payroll)
Savings (future asset protection)
Protection (insurance) (past and future asset protection)
Living - Present
Housing (Rent or Mortgage Payment)
Housing and Other Debt Payments

A

Income Statement Targeted Example Benchmarks
Targeted Example Benchmarks
15-30% Taxes (income and payroll)
10-18% Savings (future asset protection)
5-12% Protection (insurance) (past and future asset protection) 40-60% Living - Present
< 28% Housing (Rent or Mortgage Payment)
< 36% Housing and Other Debt Payments

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12
Q

4 types of ratios for the FINANCIAL STATEMENT AND RATIO ANALYSIS APPROACH ?

A

Liquidity ratios: Client’s ability to meet short-term obligations.

Debt ratios: indicate how well the client manages debt.

Ratios for financial security goals: - indicate
the progress that the client is making toward achieving long-term
financial security goals.

Performance ratios: indicate the adequacy of returns on
investments, given the risks taken by the client.

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13
Q

Name 2 Liquidity Ratios:

A

Emergency Fund Ratio

Current ratio

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14
Q

What is the current ratio ?

A

Cash and cash equivalents
————————————————- = Current Ratio 1 to 2 benchmark Current Liabilities (short term w/in 12 mns)

  • Ability to meet short-term obligations as they come due. Current liabilities represent those liabilities that will be paid within the next year.
  • If ratio too high may need to get money into more growth investments
  • If too low may need to increase Emergency cash and cash equivalents
  • Higher IS BETTER - implies more liquidity and thus a greater ability to pay current liabilities as they come due.
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15
Q

There are 4 debt ratios
used in the financial statement and ratio analysis approach to help the planner determine how well the client manages debt ?

A

Housing ratio 1 (basic)

Housing ratio 2 (broad)

Debt-to-total assets ratio

Net worth-to-total assets ratio

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16
Q

Define the Debt Ratio “ Housing Ratio 1 “ ?

A

Housing cost ( P &I, Insurance, Prop. Taxes )
——————————————————————— = < 28%
Gross Pay (monthly)

-Calculate the % of gross pay that is devoted to basic housing.

  • Includes principal payments on the mortgage (or rent), interest, homeowners insurance, property taxes, and association dues, if applicable

-Does NOT include = utilities, lawn care, maintenance, etc.

-The benchmark for housing ratio 1 is less than or equal to 28 percent.

-Generally, a HR1 of 28 percent or less is the initial ratio necessary for a first time home buyer to qualify for a conforming (best) rate mortgage.

Used by mortgage lenders.

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17
Q

Define Housing Ratio 2.

A

Housing cost + other debt payments
————————————————————————– = < 36%
Gross pay (monthly )

  • Housing ratio 2 (HR2) combines basic housing costs (HR1) with all other monthly debt payments,
  • Other payments include :
    Car, Boat loans, student loans, bank loans, revolving consumer loans, credit card payments, and any other debt payments made on a recurring basis.
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18
Q

Define the Debt to total Assets ratio.

A

Total Debt
————————————- = benchmark depends on age
Total Assets

  • Leverage ratio.
    -Reflects the portion of assets owned by a client that are financed by creditors
  • Lowers when debt decreases
    -Higher with more debt ( when young )
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19
Q

Define the Net Worth -to- Total Assets Ratio.

A

Net worth
—————————————————= Benchmark depends on age
Total Assets

Provides the percentage of total assets owned or paid for by the client.
- The higher the better !
- Best to review over time, to see the number grow with less debt.

20
Q

List the 2 Ratios for Financial Security Goals ?

A

Savings ratio = savings + Employer Match / Gross pay = min 10-13%

An appropriate savings rate is critical to achieving long-term goals including retirement, education funding, large lump-sum expenditures (e.g., second home), and legacy plans.

Note: dividends, interest, capital gains, and other types of portfolio income are not counted or included as part of savings since this type of income is already considered as part of the overall portfolio rate of return, which is used for growth projections.
________________________________________________________________________
Investment Assets to Gross Pay

Investment assets + Cash and equivalents / gross pay = benchmark by age

The combination of these two ratios provides the planner with a better understanding of the current progress toward achieving the retirement goal. The investment assets-to-gross pay ratio is the second ratio used to assess a retirement plan that persistently has clients saving 10 to 13 percent of gross pay

21
Q

What is superannuation ?

A

This kind of situation increases the probability of running out of money before the end of life (superannuation).

22
Q

Define performance ratios ?

A

Return on Investments ROI = Return on the investment during year
ROI = I1 - ( !0 + savings )
———————— = benchmark of 8-10%
I0
Appropriate measure of the return on investments made during a year. There is an implicit assumption that savings are made in equal monthly deposits during the year. This calculation produces what is referred to as an arithmetic return (AR), which is appropriate for a one-year period.
________________________________________________________________________
Return on Net assets = (ROA) ratio measures total asset returns by calculating the difference between ending assets (A1) less the sum of beginning assets (A0) plus any savings (S), divided by beginning assets.
ROA = (A1) - ( A0 + savings )
—————————– = benchmark of 2-4%
A0
________________________________________________________________________
Return on Net worth = (RONW) The Return on Net Worth (RONW) ratio further refines the performance set of ratios by calculating the rate of return on net worth. The calculation takes ending net worth (NW1) less the sum of beginning net worth (NW0) and savings (S), divided by beginning net worth.

RONW = NW1 - ( NWo + savings )
——————————— = the higher the better( less debt)catastrophic risk exposures
NWo
NOTE - If the client is adding assets with debt, this ratio should help to clarify the validity of the ROA ratio.

23
Q

What are the 3 panels within the 3 panel approach to financial analysis ?

A

Risk Management of Personal, Property, and Liability Risks -catastrophic risk exposures, life, LTC, Disability

Short-Term Savings and Investments & Debt Management = money spent on housing debt and other debt

Long-Term Savings and Investments - retirement, education, legacy

24
Q

The two-step approach considers savings and investments as part of the financial plan leading to financial security (and independence).
a. True b False

A

True

25
Q

Define the Metrics approach to financial analysis ?

A

Provides quantitative example benchmarks for the financial planner and client to use as guidance for necessary comprehensive financial goals and objectivity.

26
Q

What is the Global Portfolio Allocation Scoring System (PASS) for Individual Investors?

A

Risk tolerance questionnaire.
PASS defines short-term as three years or less, intermediate-term as three to seven years and long-term as more than seven years. With the PASS score and the time horizon, the asset allocation can be determined.

27
Q

Define the Present value goals approach to financial analysis ?

A

The present value of all goals approach considers
each short, intermediate, and long-term goal.

The first step for this approach is to determine the present value of each goal.

The next step is to sum these present values together and reduce them by the currently available resources (investment assets and cash and cash equivalents).

Finally, the net present value is treated as an obligation to be retired over the remaining work life expectancy at a discount rate equal to the expected portfolio rate of return

28
Q

Define the “CASH Flow Approach” to financial analysis ?

A

Annual current income statement and adjusts the cash flows by forecasting what they would be after implementing all of the planning recommendations.

29
Q

The Cash Flow approach separates the recommendations into 4 impact categories:

A

-No cash flow impact.

-Annual recurring positive (very few) or negative cash flow impact.

-One-time non-recurring positive (sale of an asset) or negative (pay off debt) cash flow impact.

-Impact that affects the client in a positive or negative way, but does not affect his cash flow on the income statement (an increase in the employer match in the 401(k) plan as a result of increased employee deferrals or the employer no longer matches thus causing a decrease).

30
Q

Define good debt.
-the Interest rate
-the debt [period

What are a good debt examples for a HOME and Car loan ?

A

Good debt tends to have two components:

LOW interest rate in comparison to expected inflation and expected investment returns,

DEBT REPAYMENT PERIOD is substantially less than the expected economic life of the asset.

Examples:
15 yr Home mortgage or Car loan with repayment period of 3 years or less are good !

31
Q

What are the 4 RATIOS used in the Financial Statement and Ratio Analysis Approach ?

A

THE FINANCIAL STATEMENT AND RATIO ANALYSIS APPROACH:

The approach uses four types of financial ratios:

LIQUIDITY ratios

DEBT ratios

Ratios for FINANCIAL SECURITY

PERFORMANCE ratios

32
Q

define reasonable debt.

A

debt repayment period is longer or the returns on the debt are positive, but less certain than for good debt
Examples
-30-year home mortgages at conforming interest rates and student loans that are for general education.
-Car loan with repayment period of 4-5 years

33
Q

Define Bad debt.

A

Bad debt is associated with:
(1) high interest rates, or
(2) when the economic life of the purchase is exceeded by the associated debt repayment period. An example of bad debt is an automobile loan with a small down payment and a 72-month term where the economic life of the automobile is three to five years.

34
Q

Define Private Mortgage Insurance (PMI) ?

A

Mortgage lender Insurance that is added to your monthly mortgage payment if you owe more then 80% of the home.

Lenders will require buyers with less than 20 percent equity in the home to pay for Private Mortgage Insurance (PMI) to protect the lender should the buyer default on payments.
The cost of PMI can range from $30 to $90 per month for each $100,000 of debt, depending on the size of the down payment.
The PMI premium will continue until the loan-to-value ratio falls below 80 percent, which could be 10 years or longer based on the amortization schedule of the loan payments

35
Q

What is closing cost for a home purchase ?

A

ABout 3 to 5 percent of the purchase price of the property (not reduced by the down payment amount).

for appraisals, a title search, the filing fee at the courthouse, origination fees, the initial escrow for homeowner insurance and PMI, and the initial escrow for property taxes.

The costs associated with a mortgage may also include the payment of “points.” A point is one percent of the loan amount. It is an additional prepaid interest charge paid as a lump sum by the borrower at closing in exchange for a lower interest rate on the loan.

36
Q

What are some of the approaches to Financial Planning,
I.E. Pie Chart Method , etc. ?

A

APPROACHES TO FINANCIAL PLANNING:

  • LIFE cycle approach
  • PIE CHART approach
  • The financial statement and ratio analysis approach
  • The two-step/three-panel approach
  • The present value of all goals approach
  • The metrics approach
  • The cash flow approach
  • The strategic approach
37
Q

What is a reverse mortgage ?

A

Permits homeowners to use their home equity while still living in the home.
With a reverse mortgage, the owner of a home (age 62 or older) that is fully paid for (or that has a substantial amount of equity) receives periodic income from a mortgage lender for a period of years or for life.
At the homeowner’s death, the lender can sell the home to generate the cash to repay the loan.

38
Q

Define the The strategic approach to financial analysis ?

A

Mission statement for client (e.g., to achieve financial security), a set of goals, and a set of objectives.

Construct a plan driven by the client’s mission statement.

Then, a needs-driven list of client goals is created.
From the list of goals, a detailed list of objectives is created that will all together result in the accomplishment of the mission of the client’s financial planning

39
Q

What the 5 objectives that are part of the “strategic Approach”
of financial analysis ?

A

Risk Management – A risk management objective may include the purchase or increase or decrease in coverage of life, disability, liability, or personal property insurance. In addition, the client may need to sell a liability associated asset that is either uninsured or uninsurable.

  • Debt Management - Objectives associated with debt management may include reducing or eliminating high interest debt, paying off credit card debt, and reducing housing ratios to appropriate levels (HR1 = < 28% and HR2 = < 36%).
  • Tax Management and Emergency Fund - For tax management purposes, the client may need to adjust income tax over withholding as an objective in order to meet other cash-required objectives. The client’s emergency fund balance may need to be increased to meet at least a three to six month balance objective.
  • Savings and Investments - Savings objectives may include creating, adjusting, or increasing amounts associated with retirement, education, or housing funding. Changing the risk of an investment portfolio or either buying or selling existing investments to fit the financial planning mission are possible investment objectives.
  • Estate Plan
40
Q

Calculate a SAVINGS RATIO :

example

$100,000 Salary,
Employee saves $10,000,
Employer matches 5%
Employee saves additional $ 3,000 into there IRA

A

Savings + Employer match (annual figures )
———————————————————————- = Savings Ratio
gross pay ( annual figure)

$10,000 + ( $100,000 @ 5% = $5,000) + $3,000
——————————————————————- = 18%
$100,000

41
Q

Calculate a Emergency Fund Ratio :

A

Cash + Cash equivalents (due w/in 12 mns)
——————————————————— = 3- 6 months of expenses
Monthly NON-Discretionary expenses

NON-Discretionary Expenses include:
- Charitable Contributions
- Church Donations
- Lawn Service
- Child Care
- Entertainment Vacations, Satellite or Cable TV

42
Q

DEBT RATIO :

What is the HR 1 Housing Ratio ?

A

Housing Cost (P & I, insurance, prop taxes) PITI
—————————————————————– = should be <= 28 %
Gross pay

  • HR1= 28 percent or less is the initial ratio necessary for a first time home buyer to qualify for a conforming (best) rate mortgage.
  • Conforming rate mortgage generally requires a 20 percent down payment and good credit.
  • As inflation causes salaries and housing values to increase, HR1 should decline gradually
43
Q

DEBT RATIO :

What is the HR 2 housing ratio ?

A

Housing cost + other debt payments
——————————————————————————- = +< 36 %
Gross Pay

Other Debt payments include :
- automobile loans,
- student loans,
- bank loans,
- revolving consumer loans,
- credit card & any debt payments made on recurring basis.

44
Q

What is the content within the

3 panel approach to Financial Planning ?

A

PANEL 1- Risk management of personal , Property and Liability Risk:
- Evaluate the need for Life insurance, Health Insurance
- Disability insurance
- LTC
- Property insurance
- Liability Insurance
——————————————————————————————-
PANEL 2 - Short Term Savings and investments & debt management:
Evaluate the adequacy of:
1. Emergency fund
2. Income % of spent on housing
3. Income % spent on debt other than housing debt repayments
———————————————————————————————
PANEL 3 - Long term savings and Investments
valuate the adequacy of progress toward:
1. Retirement goal
* the savings rate
* investment assets
2. Education funding goal
3. Large purchase goal
4. Legacy goals
* documents (e.g., wills)
* financial

45
Q

The Life Cycle Approach to financial Planning:

What are the 3 different Life Cycle Phases ?

What are the characteristics of each ?

A
  • ASSET ACCUMULATION phase :
  • Early 20s to mid 50s
    Low Discretionary cash flow
    High debt-to-net worth ratio
  • CONSERVATION (risk management) phase :
    -Begins late 20s - the early 70s,
    Increased - Cash flow, Assets, Net worth
    Decreased - debts
    Risk management of events like unemployment, disability due to illness or accident, and untimely death become a priority.
  • could be right before retirement
  • DISTRIBUTION (gifting) phase:
    -Begins in the mid 40s or early 50s - the end of life.
    HIGH Cash flow,
    High Net worth.
    Low Debt
46
Q

A client in the asset accumulation phase is characterized by:

A. Discretionary cash flow for investing is low and debt to net worth is low.

B. Discretionary cash flow for investing is high and debt to net worth is high.

C. Discretionary cash flow for investing is high and debt to net worth is low.

D. Discretionary cash flow for investing is low and debt to net worth is high.

A

D. Discretionary cash flow for investing is low and debt to net worth is high.

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