Lesson 5 - Financial Statements and Analysis

Question 1

Current Ratio

Answer 1

Current Assets/ Current Liabilities

Question 2

Emergency Fund

Answer 2

current assets / monthly non discretionary expenses

Question 3

Debt Ratios

Answer 3

• Consumer debt payments should not exceed 20% of NET income.
• Housing debt should be less than or equal to 28% of GROSS income.
• Housing plus all other recurring debt should be less than or equal to 36% of GROSS income.

Question 4

Housing Ratios

Answer 4

Housing – 28% Ratio
Monthly Housing Costs (P+I+T+I) /Monthly Gross Income

Ratio should be 28% or less

• P = Principal
• I = Interest
• T = Taxes (Property)
• I = Homeowners Insurance

Do not subtract taxes or savings from gross income when calculating the 28 or 36% ratios. The formula requires GROSS income.

Question 5

Housing & All Other Debt Ratio

Answer 5

– 36% Ratio
Monthly Housing Costs (P+I+T+I) All Other Recurring Debt Payments/ Monthly Gross Income

Ratio should be 36% or less

• P = Principal
• I = Interest
• T = Taxes (Property)
• I = Homeowners Insurance
• All other recurring debt includes: auto, student loans, boat, credit card and any other type of monthly debt

Question 6

A young couple would like to purchase a new home using one of the following mortgages:

1: 10.5% interest with 5 discount points to be paid at time of closing.
2: 11% interest with 2 discount points to be paid at time of closing.

Assuming the couple could qualify for both mortgages, which of the following aspects should be considered in deciding between these mortgages. (CFP® Certification Examination, 11/94)

1. Gross income.
2. Estimated length of ownership.
3. Real estate tax liability.
4. Cash currently available.

a) 1 and 2.
b) 2 only.
c) 2 and 4.
d) 4 only.
e) 1, 2, 3, and 4.

Answer 6

Answer: C

1. Gross income – NO, they already qualify, per the question
2. Estimated length of ownership – YES, payback on lower rate vs. points
3. Real estate tax liability – NO, same property, same taxes, they already qualify
4. Cash currently available – YES, higher points, higher initial cost

Question 7

Daveed owns a primary residence on Miami beach for $3.0 million. Ten years ago, he put 20% down on the house and finance the rest at 4.25% over 15 years. He is looking to refinance his home to pay for a new roof. His roofing estimate is $80,000. The mortgage officer at the local bank offered Daveed the following refinance options. Which option will result in a lower payment?

1. His remaining balance plus $80,000 financed for 15 years at 3.75%
2. His remaining balance plus $80,000 financed for 15 year at 3.68% with Daveed paying 2 points.

a) Loan option 1 will result in a lower monthly payment. b) Loan option 2 will result in a lower monthly payment.

Answer 7

Answer: A The first step is to figure his current balance. PV = 2.4 million, n = 15 x 12, i = 4.25%/12, solving for PMT = $18,054.68 Step 2 Use Amortization to find the balance after 10 years; 12c: 120 f AMORT, f INT, x>

Question 8

Savings Ratio

Answer 8

Annual Savings (Employee + Employer Contributions) / Annual Gross Income
- A benchmark savings ratio target is 10-12% of gross income if the client starts saving before age 32. - If a client waits to begin saving at 45 or 50, the rate may be 20-25% of gross income. - It’s important to include employer contributions to 401(k), profit-sharing plans, etc., as part of the savings ratio calculation

Question 9

Karen has a salary of $50,000 per year and she saves 10% of her salary in her 401(k). Her employer matches $1 for each dollar contributed, up to 3% of her salary. Her employer also con-tributes $2,500 to a profit-sharing plan for her. What is Karen’s savings ratio?

Answer 9

EE Contribution = $50,000 x 10% = $5,000 ER Contribution = $50,000 x 3% = $1,500 + $2,500 in profit share Savings Ratio = ($5,000 + $1,500 + $2,500) / $50,000 = 18%

Question 10

Rate of Return on Investments (ROI)

Answer 10

ROI=( Ending Investments - Beginning Investments – Savings - Gifts Received ) / (AverageInvestedAssets)

Average invested assets = (beginning investments + ending investments) / 2

• ROI should also be compared with an appropriate benchmark based on a client’s age and risk tolerance. - ROI provides some insight as to the likelihood of achieving goals.

Question 11

Kevin has an annual salary of $100,000. His fixed expenses are $60,000 and his variable expenses are $35,000 per year. His invested assets at the beginning of the year were $50,000. At the end of the year his invested assets were $70,000. Assuming savings are not part of variable or fixed expenses, what was Kevin’s ROI?

Answer 11

Savings = $100,000 – $60,000 – $35,000 = $5,000 Average Invested Assets = ($50,000 + $70,000) / 2 = $60,000 ROI = ($70,000 – $50,000 – $5,000) / $60,000 = 0.25 or 25%

Question 12

Limitations of Financial Statement Analysis

Answer 12

Inflation - Inflation makes it difficult to compare financial statements from one period to the next.
Use of Estimates - Any type of net worth calculation includes personal use assets. Personal use assets are typically stated at an estimated fair market value
Benchmarks - There are very few benchmarks for personal financial ratios. - Benchmarks serve as a rule of thumb but individual circumstances may cause a benchmark to be irrelevant
EXAMPLE
Bill Jr., the son of Bill Gates, has a trust fund of $100,000,000 that pays him an annual income of $1,000,000 per year for the rest of his life. The savings ratio benchmark of 10-13% becomes irrelevant at that point.