Lesson 6 of Fundamentals: Financial Statements and Analysis Flashcards
Personal Financial Statements
Used as a scoring mechanism for capturing and analyzing an individual’s financial position and performance.
Financial Statements Include
Balance Sheet:
- CFP board may call it a “Statement of Financial Position” or
- “Net Worth Statement”
Income and Expense Statement
- (CFP board may call it “Cash Flow Statement”)
Balance Sheet
- Listing of Assets, Liabilities, and net worth
- A snapshot of account balances in a moment in time.
- Proper dating is “As of December 31, 20xx”
Formula:
Assets - Liabilities = Net Worth
Assets
- Property that is owned or partially owned by the client.
- All assets are stated at FMV.
Fair market value
The price at which a willing buyer is willing to buy and the price at which a willing seller is willing to sell.
Cash & Cash Equivalents or Current Assets
Current Assets or Cash & Cash Equivalents Examples
- Cash
- Checkings
- Money Market
- CD (12 months or less maturity)
- Includes laddered CDs set to mature every 6 months.
- Includes anything client will convert to cash within 1 year.
Invested Assets
Examples:
- Stocks
- Bonds
- Mutual Funds
- Retirement accounts (IRA)
- Business ownership
- Any assets maturing in greater than 12 months.
- EE Savings bond
- Brokerage
Personal Use Assets
Examples:
- Personal Residence
- Car
- Furniture
- Boat
- Clothing
- Includes any assets used to maintain the client’s lifestyle.
Liabilities
- Stated at Principal Outstanding
- Debt obligations that are owed by the client.
- Are classified according to the timing of when they are due.
- Either current or
- long-term liabilities.
Mortgage can be in both Current and Long Term.
Current Liabilities
(Short Term Liabilities)
Obligations due within 12 months.
It includes interest unless already incurred.
Example:
- Credit cards
- Taxes Payable
- Unpaid bills (Utilities, Cable, cell phone)
Long term Liabilities
Remaining balance on any outstanding debt beyond 12 months.
Examples:
- Outstanding balance on a loan for a client:
- House
- Car
- Boat
- Other outstanding Loan
Net Worth
Difference between assets and liabilities.
What does the balance sheet not explain?
- Why or how an asset increased in value?
- Whether the client bought more of the asset or did the asset appreciate?
- Why or how an asset or liability appear on the balance sheet?
- Whether the client purchased an asset or inherited the asset?
- Does not explain the changes in net worth.
- Whether the increase in net worth is the result of added savings, inherited assets, appreciation of assets, or debt retirement.
Statement of Income and Expenses
Listing of income, savings, expenses, and taxes. Also Called Statement of Cash Flows
Income:
- Salary
- Interest
- Dividends
- Business Income
Savings:
- Outflow to retirement plans
- Education savings
- Any other Savings account
Expenses:
- Variable
- Fixed
- Presents income and expenses over a period of time
- Proper dating would be, “For the Year 20xx”
Discretionary Cash Flows should be postive which means good, negative means bad.
Fixed Expenses examples
- Mortgage
- car payments
- boat payment
- student loan payment
- Any expenses that remain constant each month
Variable expenses examples
- Car repairs
- Entertainment expenses
- Utilities
- Charitable contributions
- Generally, any expense over which the client can control.
Example: Purchasing a new bedroom suite
What does a Cash Flow Statement not do?
- Consider an employee’s contributions to retirement plans (only captures and reports employees’ contributions to a savings account.)
- Captures and report the giving or receiving of gifts or inheritance
Exam Question - Financial Statements
During the gathering phase of the financial planning process, a client provides a financial statement of cash flows to a CFP certificate. The financial statement will provide the certificate with an understanding of all the following?
a) Variable Expenses
b) Income Taxes Paybale
c) 401 (k) savings contributions
d) Discretionary Cash Flow
B- Income Taxes Payable
Would appear on the current liabilities of the balance sheet. (Statement of financial position)
Financial Statement Analysis
Provides us insight into a client’s strengths and weaknesses.
Allows us to answer questions to:
- How well does the client manage debt?
- How well client is progressing toward the financial goals?
- How well client is able to meet short-term obligations?
Limitations of Financial Statement Analysis
Only Provides us with a historical perspective.
Not a predictive of the future.
Ratio Analysis
Science + Art
Science: Calculating the ratio
Art: Providing meaning and insight to the ratio.
Objective of Ratio Analysis
Gain additional insight into the financial situation and behavior of the client.
Generate questions for the client to further gain insight.
Example:
- If the client has a low savings rate and high variable expenses, can the client adjust any variable expenses to increase the savings rate?
Liquidity Ratios
Measure the ability of a client to meet short-term or current liabilities.
- Current Assets
- Emergency Fund
Debt Ratios or Debt Analysis
Indicates how well a person manages their overall debt.
Performance Ratios
Assess the financial flexibility of the client, as well as the client’s progress toward goals.
- Savings Ratio
- Rate of Return on Investments (ROI)
Current Ratio
MEMORIZE FORMULA
Current Assets / Current Liabilities
A measure of a client’s ability to meet short-term obligations.
Current Assets Include
- Cash and Cash equivalents
- Marketable securities (such as certificates of deposits less than 12 months in maturity)
- Money Market
- Savings
- AR
- Checking Accounts
Current Liabilities Include
Credit Cards
Short-term debt due in less than 12 months
Emergency Fund
Clients need 3-6 months in non-discretionary expenses in an emergency fund.
Credit card or line of credit is okay if the client is NOT disabled
Current assets include
- cash,
- checking,
- money market,
- savings,
- short-term CD,
- US T-bills,
- life insurance,
- cash value, and
- money market mutual funds.
EXAM TIP: 3 months for a dual wage earner family, 6 months for a single wage earner family.
Make sure to divide by 12 if it gives it in annual. Looking for Monthly.
Nondiscretionary expenses
Expenses that do not go away if you lose your job.
Examples:
- Mortgage
- Utilities
- Food
- Car Loan
- Property Taxes
- Insurance Premiums
What is not a nondiscretionary expense?
Income taxes
Payroll taxes
Contributions to a retirement savings account.
Exam tip
If the CFP exam gives you a combined fixed and variable expenses rather than non-discretionary expenses, use the combined fixed and variable expenses as a substitute for nondiscretionary expenses.
Emergency Fund Formula
Current Assets / Monthly Non-Discretionary Expenses
Emergency Fund Practice
Your client’s current assets are $15,000. Monthly nondiscretionary expenses are $5,000 and monthly discretionary expenses are $2,000 What is the client emergency fund?
Current Assets / monthly discretionary expenses
=$15,000 / $5,000
=3.0 months
Debt Ratios
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.
Housing 28% Ratio Formula
(Sometimes Called Front End Ratio)
Monthly Housing Costs (P+I+T+I) ÷ (Monthly Gross Income)
P = Principal
I = Interest
T = Taxes (property)
I = Homeowners Insurance
Also Include the MONTHLY HOA Amount in Numerator.
Do not subtract taxes or savings from gross income when calculating the 28% or 36% ratios. The formula requires GROSS income.
Housing & All Other Debt Ratios
(Sometimes Called the Back End Ratio)
Monthly Housing Costs (P+I+T+I) + (All Other Recurring Debt Payments)
÷
(Monthly Gross Income)
P = Principal
I = Interest
T = Taxes (property)
I = Homeowners Insurance
All other recurring debt includes:
- Auto,
- student loan,
- boat,
- credit card and
- any other type of monthly debt
Same Thing Where You Should Include MONTHLY HOA Dues In The Numerator.
Exam Tips:
- Auto Insurance would not be debt
- Variable expenses would not be debt.
When to buy housing purposes?
- Client’s time in the property is going to be long (> 3 years)
- Client going to build equity
- If the client is in a high marginal tax bracket because of the income tax deduction for interest expenses associated with the client’s primary residence.
Exam Tip: Primary Driver to rent or buy is TIME
When to rent or lease housing purposes?
Client’s time in the property is going to be short (1-3 years).
Mortgages
- Up to $750,000 max indebtedness (condition of owing money) can be considered for interest itemized deduction.
- Up to $750,000 in max indebtedness can include a home equity loan if it is used for repair or improvements of the home
Conventional Mortgages
Has a fixed interest rate for the duration of the loan.
- Default Answer on the CFP Exam.
Adjustable rate Mortgage (ARM)
Appropriate when the client’s time in the property will be short (1-3 years).
- A 2/6 ARM means the interest rate cannot increase more than 2% per year, or 6% during the term of the loan.
Loan Estimate (LE):
- Describes the type of Loan and itemizes service and fees charged by the lender when applying for a loan or refinance.
Exam Tip:
- On the CFP Exam, if the mortgage rates are going to decrease and the person only plans to stay there for a specific period of time like 5 years, then this would probably be the answer.
Example of ARM
Shania enters into an adjustable rate mortgage at 4%, when the 30-year mortgage is 6.5%. The ARM is 2/6 with no penalty for early payments. What is the maximum interest rate Shania could expect to pay on the ARM?
4% + (2% + 2% + 2%)
= 10%
The risk is that the mortgage will become too expensive in years 2 and 3 if interest rates increase each year for three years.
Loan Estimate (LE)
Describes the type of loan and itemizes services and fees charged by the lender when applying for a loan or refinance.
Reverse Mortgages
- Homeowners receive a monthly payments or lump sum from a bank while retaining the right to live in the house.
- Repayment of the outstanding mortgage occurs at the homeowner’s death.
- Appropriate to generate income for elderly homeowners.
- Available if the homeowner is 62 years or older.
Mortgage Calculations to Know
**NEED HELP PG.99
- Monthly/annual mortgage payments.
- Interest expense reductions
- Refinance with points
- Principal Reductions
Discount Points
- Pay a higher upfront fee for your home loan so you can have a lower monthly mortgage payment for the life of your loan.
- New Balance of Mortgage: $1,000,000 w/ 2 points.
- = 1,000,000 * (1+.02) = 1,020,000
Lender Credit
- Allows the home buyer to buy their home when they do not have enough money to cover the closing costs.
Savings Ratio Formula
Memorize Formula.
- Annual Savings (Employee + Employer Contributions) ÷ Annual Gross Income
Memorize Formula. Know Employer Contributions
Savings Ratio
- Is a performance ratio
- A benchmark savings ratio target is 10-12% of gross income if the client starts saving before age 32.
- If a client waits to begin saving at 45 or 50, the rate may be 20-25% of gross income.
- It’s important to include employer contributions to 401(k), profit-sharing plans, etc as part of the savings ratio calculation.
Not necessarily going to test you on 10-12$
Rate of Return of Investments Formula (ROI)
Memorize Formula
(Ending Investments - Beginning Investments - Savings - Gifts Received) ÷Average Invested Assets
Average Invested Assets
(Beginning Investments + Ending Investments) ÷ 2
Rate of Return of Investments (ROI)
- A performance ratio
- Target of 9%-12% depending on the clients age + risk tolerance.
- Should also be compared with an appropriate benchmark based on a client’s age and risk tolerance.
- Provides some insight as to the likelihood of achieving goals.
ROI Example
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?
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 = 25%
Limitation of Financial Statement Analysis
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 stated at 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.
Mortgage Refinancing
The decision to refinance is
- usually based on a new comparison of the upfront costs (especially points paid) to obtain a new mortgage with the ongoing benefits provided by the lower interest rate in it.
The motivation usually is to lower the monthly payments
- because of the lower interest rates.
- Lowering monthly payments can free up funds to be saved toward goals or to a deficit budget.
Mortgage Refinancing Example
Things You Need to Know How to Do:
- Calculate PMT of the Mortgage after x amount of years
- Calculate the remaining balance (Amortization)
- Calculate Amount of Interest
- Calculate New PMT
- Calculate Remaining Payments
- Calculate How Much You Would Save in interest
- Calculate How Much You would Save Mer Month because of the lower payment
Exam Tip:
- The Closing Costs should only be added if they tell you they are adding it. Or they could say “Customer is Paying Closing Costs at a outside source.
Practice Question - Refinancing
Clients visit their CFP Professional regarding a refinance on their house. What are the best documents the CFP professional should use to evaluate whether to refinance the house.
a) Loan Estimate
b) Current monthly mortgage statement
c) Original Loan Documents
d) Current real estate taxes
e) Both a & c
Answer: E
B would also be good too, but it isn’t the best option.
