LO 3.1.3: Evaluate a client’s financial situation through use of applicable ratios - LO 3.1.4: Assess the strengths and weaknesses

Question 1

Financial ratios

Answer 1

Gives picture of client’s situation; used in comparison with established benchmarks to make judgments as to their appropriateness

Question 2

Ratio analysis - intention

Answer 2

to provide perspective and insight into a client’s financial situation and behavior

Question 3

Consumer Debt Ratio

Answer 3

Consumer debt ratio = monthly consumer debt payments / monthly net income

• Uses monthly net income (after taxes)
• Not exceed 20% of net monthly income, gives us an idea of whether clients are carrying way too much debt.
• Refers to debt other than mortgage payment
• AKA. nonmortgage debt-to-income ratio

Question 4

Net Income

Answer 4

Gross income less taxes

Question 5

Housing Cost Ratio

Answer 5

Housing Cost Ratio = Monthly housing costs / Monthly gross income

• Uses monthly gross income (b4 taxes)
• Not exceed 28% of gross monthly income
• AKA. the front end test
• AKA. the 28% test

Question 6

Monthly housing costs

Answer 6

Include PITI (principal, interest, property taxes, and insurance) for any home that we have purchased

• Do NOT include maintenance or utilities, upkeep etc.
• Includes expenses that are not debt (taxes, insurance, assoc. fees)

Question 7

Total Debt Ratio

Answer 7

Total Debt Ratio = Total monthly debt / gross monthly income

• Uses monthly gross income (b4 taxes)
• • Not exceed 36% of gross monthly income
• Important: use the minimum required debt payment (97)
• Gauges a loan applicant’s ability to assume more debt or for planners if debt is excessive

Question 8

Why does housing cost ratio and total debt ratio use monthly gross income

Answer 8

Mortgage interest may be tax deductible, so we use gross income in the Housing and Total Debt ratios.
* Consumer debt is not tax deductible, so Consumer Debt Ratio is on a net income/take-home-pay (after-tax) basis (97)

Question 9

Current Ratio

Answer 9

Current ratio = Current assets / Current (short-term) liabilities

• Represents the ability of an individual to pay of short-term debt in liquid cash in case of a financial emergency.
• No accepted standard ratio, near 1 is good
  
  • > 1.0 indicates enough liquid assets (like cash) to pay off existing short-term liabilities
• Higher ratio (> 1.0) preferred
• AKA. liquidity test

Question 10

Net-Investment-Assets-To-Net-Worth-Ratio

Answer 10

Net-Investment-Assets-To-Net-Worth-Ratio = Net investment assets / net worth

• Compares value of investment assets with net worth
• Excludes the home
• Ratio should amount to at least 50%, % gets higher as retirement approaches
• Younger: likely <20% bc haven’t had time to build an investment portfolio
• Measure is used for proper advancement toward capital accumulation goals

Question 11

Financial strengths

Answer 11

• 1. Adequate savings (particularly for retirement)
• 2. Appropriate emergency fund
• 3. Appropriate net worth, given client goals
• 4. Well-defined financial goals
• 5. Excellent cash flow management skills (including proper debt management)
• 6. Appropriate investments given risk tolerance, time horizon, and goals
• 7. Appropriate insurance coverage
• 8. Valid and current estate planning documents
• 9. Employment status stable or promising (growing field)

Question 12

Financial weaknesses

Answer 12

• 1. Insufficient savings (particularly for retirement)
• 2. Inadequate emergency fund
• 3. Low net worth, given client goals
• 4. Financial goals that are not defined or unrealistic
• 5. Poor or improper cash flow management skills
• 6. Investments that are not aligned with risk tolerance, time horizon and goals
• 7. Insufficient amount or no insurance coverage
• 8. Lack of estate planning documents
• 9. Unfavorable employment status (declining field)