Financial Management (37 questions) Flashcards
TDSR (Total Debt Service Ratio)
is an affordability ratio that compares the cost of owning or renting a home and payments on all other outstanding debts to the borrower’s gross income.
For renters, TDSR is calculated as:
- (rent + heating + consumer loans) / gross monthly income
For home owners, TDSR is calculated as:
-((mortgage payments + property taxes + heating + 50% condo fees + payments for other personal loans) / gross income))
If is used by landlords to determine if someone who is applying to rent a home can realistically afford to pay the rent.
Closed end lease vs open end lease
In a closed end lease, the lessee pays a fixed monthly amount in exchange for the right to use the asset for a specified period of time, although the contract may include an automatic adjustment for inflation if it is a long-term lease. When the lease expires, the lessee has no further obligation, unless she caused significant damage or unusual alterations to the property.
In an open-ended lease, the payments tend to be lower, but when the lease expires, the lessee may be required to make an additional payments if the property cannot be sold or rented for less than the amount that it was anticipated when the first lease was executed.
Primary purpose of budgeting
Control Spending
Budgeting is the process of setting realistic spending targets, and monitoring spending over time to see if those targets are being achieved. Before a budget can be prepared, the client will need to gather data on their past spending patterns, to determine which expenses are discretionary and which are non-discretionary. This information can be used to develop reasonable spending targets. Once the budget has been prepared, the client should routinely compare his actual expenditures with the targets. If their spending exceeds the targets, either the budget needs to be modified because the targets were not realistic, or the client must better control their spending.
Only once spending is under control can the client begin to make plans for investments or future savings.
Money management strategies to control spending
- pay yourself first involves directing a portion of each paycheck automatically to a savings account or investment vehicle.
- controlling spending on incidental and impulse purchases
- the wise use or credit can be a part of a sound money management plan, for example, using a credit card and paying the balance each month to avoid interest charges.
- in most cases, interest charges are not deductible ad must be paid with after tax dollars. In addition, interest rates charged on some forms of credit, such as credit cards, are extremely high. For this reason, it is important to pay off debts quickly.
Equity ratio for personal assets
((assets - liabilities) / assets))
Bankruptcy
According to the bankruptcy act, an individual is insolvent if he is not yet declared bankrupt, but:
- his obligations to his creditors exceed $1000 and he cannot meet his obligations as they come due
- he has ceased paying his debt obligations; or
- he has debts due and accruing that exceeds the value of his assets
An individual can also be declared bankrupt if he is insolvent and he voluntarily declares himself as bankrupt, or his creditors are successful in lodging a receiving order against him.
However, creditors cannot make a petition for bankruptcy against any individual who is solely engaged in fishing or farming, or any wage earner who does not earn more than $2500 or who does not carry on any business on his own account.
Creditors may also be able to force a person into bankruptcy even if they are not insolvent, if that person has committed an act of bankruptcy, which could include:
- assigning assets to a trustee in a manner that is not satisfactory to his creditors
- fraudulently transferring his assets to a third party in anticipation of bankruptcy, with the intention of withholding those assets from distribution to his creditors
- paying off one creditor in preference to the outstanding claims of other creditors
- failing to give up goods that are to be seized under an execution order.
- trying to depart secretly and suddenly, with the intention of defrauding his creditors; or
- failing to meet his liabilities as they come due.
Statement of lifestyle expenditures
purpose is to show the cost of sustaining the client’s lifestyle, including non-tax-deductible interest expense for mortgages, car loans, personal loans, etc. It does not include income taxes, tax deductible expense or capital expenditures, such as payments on mortgage principal, because these are not costs of maintaining a certain lifestyle and they are taken into account elsewhere.
Statement of cashflow
purpose is to show the cash from sources of income, cash outlays for expenses, cash flows from net investment assets and cash flows from net personal assets. If includes both lifestyle and capital transactions.
Statement of net worth
purpose is to show assets, liabilities, and net worth as at the start and end of the year. Net worth is the sum of assets less liabilities (including deferred income taxes). As such, it is affected by capital transactions (the purchase or sale of capital assets), plus the unrealized appreciation and depreciation of these assets over time.
Pro forma statements
When a financial planner evaluates the impact of recommended financial strategies, they may prepare a projection of what these statements would look like in one or two years, based on his assumptions and the recommendations.
This is called a pro-forma statement.
Mental accounting
refers to the tendency for people to divide their money to separate mental accounts based on a variety of subjective criteria including the source of the money and the intended use of the money allocated to each account. The physical location of the money and mental “location” may be totally disassociated.
The money allocated to a particular account may be allocated for a particular objective. Each objective could have a different importance, both priority and urgency and this importance would have significance in determining the use of these mental funds.
Availability heuristic
Is the use of readily available information with emphasis on its vividness and emotional impact in the prediction of an outcome, rather than more objective information. The availability bias is error or distortion arising from the use of he availability heuristic.
Denial heuristic
is the avoidance of information with negative emotional impact in the prediction of an outcome. The very act of thinking about such information can lease to an increased refusal to believe it might occur. A denial bias is error or distortion arising from use of the denial heuristic.
Hindsight heuristic
is the tendency for a person to reconstruct a judgement or choice based upon currently available information, rather than the information used to formulate the original judgement or choice. A hindsight bias is error or distortion arising from the use of the hindsight heuristic.
Anchoring heuristic
is the common human tendency to rely heavily on one reference point when making a decision - even though that reference point may have no logical relevance to the decision at hand. The reference point could be a trait, value or other piece of information. During decision making, an individual may start with an anchor and then adjust that value to account for other aspects of the circumstance. Anchoring is prevalent in situations where a person is dealing with concepts that are new and novel. The tendency to anchor is so strong that it occurs in situations where the anchor is absolutely random. An anchoring bias is error or distortion arising from the use of the anchoring heuristic.
