Module 2 - Business Ownership, Cash Management and the Use of Debt Flashcards
What three categories can assets be separated into?
Cash / cash equivalent (liquid assets) - includes resources that can readily be converted to cash with little, if any, loss of principal (checking, savings accounts, CDs money market funds, life insurance cash values - which can be borrowed)
Invested assets - includes holdings such as stocks, bonds, mutual funds, precious metals, collectibles you intend to sell, real estate, and other similar assets
Use assets (things you buy to keep) - includes property that is not available for repositioning to meet financial objectives. Generally will include primary residence, automobiles, boats, and other personal effects such as household furnishings, clothing, jewelry and similar assets that you intend to keep.
In a statement of financial position (balance sheet), how do you list value for assets?
Assets are show at their current FMV
What is included under liabilities on a statement of financial position (balance sheet) and how do you categorize them?
Any debt an individual is currently carrying or assuming - e.g. mortgage, auto loan, credit card balance.
Liabilities may be categorized as either short term (S/T), to be paid off within one year, or long term (L/T), and are generally listed in the order in which they are due.
Define “net worth”
The difference between assets and liabilities.
How should you view “footnotes” in personal and corporate financial statements?
Should be taken into consideration in all planning. DO NOT ignore them, since footnotes often explain and clarify some very essential items in the statement or indicate values or circumstances not disclosed elsewhere in the body of the statement.
Cash Flow statement (Income statement)
Reveals cash receipts and disbursements over a specific past period of time - usually one year. It summarizes the inflows and outflows of cash, showing all sources of income and patterns of spending, saving, and investing.
How do you track credit card spending in an cash flow statement
it’s important to list any credit card charges in the proper category the $$ were used for - example: if you spend $4,000 on CC to pay for a vacation but only list $4,000 in a “credit card” category as opposed to the vacation category, you can cover up the vacation outflow and distort the cash outflow picture.
What are 6 major areas to be evaluated when analyzing a client’s financial situation?
1) Emergency fund
2) Level of debt
3) Level of savings
4) Diversification of assets
5) Preparation for retirement
6) Tax Issues
Define liquidity and marketability
Liquidity represents the ability of an asset to be converted quickly and easily into cash with little or no loss to principal.
Marketability is the ease of buying and selling an asset at any price.
What is the formula for calculating basic liquidity ratio? What’s the basic guideline for this and and what does it tell us?
Basic liquidity ratio = cash & cash equivalents / (monthly expenses - savings - taxes)
Basic guideline is to have liquid assets equal to 3-6 months’ expenses in an emergency fund, with 3 month benchmark used when both spouses are working full time and the 6 month benchmark used when only one spouse is working full time.
This shows the number of months a household could continue to meet its expenses from existing cash and cash equivalent assets after a total loss of income.
Define the “savings ratio”, what’s the formula and what is considered healthy?
It’s an indicator of what percentage of gross income a family or individual is setting aside for future consumption. A ratio of 10% or higher is considered healthy.
Savings ratio = savings & investments / total income
The earlier one starts to save, the better. The later one starts, the higher the savings ratio will need to be in order to meet future income goals.
What are the two primary forms of debt-to-income ratios?
The first is known as “front-end ratio” and indicates the percentage of income that goes towards housing costs (which for homeowners includes PITI - principal, interest, taxes, and insurance) and HOA fees when applicable.
Housing should not exceed 28% of gross monthly income.
The second is known as “back-end ratio” and identifies the percentage of income that goes towards paying all recurring debt payments, including those covered by the front-end ratio, and other debts such as CC payments, car loan payments, student loan payments, child support, alimony, and legal judgements.
The max measure for this ratio is 36% of gross monthly income.
Debt-to-income “front-end” ratio - what’s the formula, what does it compare, what percentage should it not exceed?
Compares the annual payments to repay housing costs, and generally should not exceed 28% of gross income.
Front-end debt-to-income ratio = annual PITI (principal, interest, tax, insurance)/annual gross income
Debt-to-income “back-end” ratio - what’s the formula, what does it compare, what percentage should it not exceed?
Compares the annual payments to repay all consumer and mortgage debts of a fixed nature with a person’s gross annual pay (including interest and dividends from investments). This ratio shows how much income, as a percentage of gross income, is used to repay debts. A ratio of 36% or lower indicates adequate current gross income to make debt repayments.
Back-end debt-to-income ratio = Annual debt repayments / annual gross income
Consumer Debt-to-income ratio - what’s the formula, what does it compare, what percentage should it not exceed?
Compares the annual payments to service debt. This ratio doesn’t include mortgage and uses a person’s annual take-home pay (net income). A ratio of 20% or lower is healthy.
Net income = Gross Income - (Income tax + SS tax)
Non-mortgage debt-to-income ratio = annual non-mortgage debt repayment / annual net income
Rule of 72
An easy way to estimate future costs. Divide the inflation rate into 72 and the result tells you in how many years the cost of an item will double (or the purchasing power of your dollars will be cut in half).
Example - a $15,000 tuition bill will cost $30,000 in 12 years, with a steady 6% rate of inflation (72/6 = 30). Alternatively, your $10,000 will become $20,000 in 8 years if it earns a constant 9% (72/9 = 8), not including the effect of taxes.
What are the options for closely held business forms / entities?
1) sole proprietorship
2) partnership
3) regular / C corp
4) S corp
5) limited liability company (LLC)
What are tax and liability characteristics for sole proprietorships?
No formal org docs or annual registration is required.
The sole proprietor is liable for the obligations of the business, with all profits / losses flowing directly through to the owner as income for income tax purposes.
Schedule C is used when filing income taxes, with company expenses subtracted from profits.
A sole proprietor can be personally sued for the products or services provided.
To lessen the liability, it can be covered with an added LLC, though it will still be taxed as a sole proprietorship on the owner’s regular tax form.
Persistent losses will be characterized by the IRS as a filer’s “hobby”, not a business; a filer should show a profit 3 out of the last 5 years to not be considered a hobby.
Tax Cuts and Jobs Act (TCJA) allows for a deduction of up to 20% to bring the tax rate lower for qualified business income.
What are tax and liability characteristics for partnerships?
Must have a business purpose and at least 2 owners.
A written agreement between the partners (partnership agreement) should be prepared with rights of each partners specified.
Should register with the partnership’s state.
Declares profits / losses and the net profit / loss flows through to the partners for income tax purposes, using schedule K-1.
Income listed on the K-1 is added to each partner’s income tax form in the income section.
Partnerships can be paired with an LLC for better liability coverage, while still taxed as a partnership.
Persistent losses will be characterized by the IRS as a filer’s “hobby”, not a business; a filer should show a profit 3 out of the last 5 years to not be considered a hobby.
Tax Cuts and Jobs Act (TCJA) allows for a deduction of up to 20% to bring the tax rate lower for qualified business income.
What are tax and liability characteristics for regular / C corps?
Separate taxable entities with their own tax rates, and therefor, do NOT permit flow-through tax treatment to the shareholder-owners.
Corp income is subject to double taxation if dividends are issued. (Profits are taxed at the corp level before dividend issue, then dividend income gained by the shareholder is taxed on their personal income tax form)
Can be paired with an LLC for greater security.
What are tax and liability characteristics for S corps?
Can elect not to be taxed as a corp, which permits flow-through income treatment to the shareholder.
In most respects, the S corp is taxed as a partnership. Stockholders are taxed on the net profits of the corp, even if they don’t receive taxable dividends.
S Corps may have no more than 100 shareholders, may only issue one class of stock, and doesn’t permit foreign ownership.
Can be paired with an LLC to reduce liability borne through the income flow-through
What are tax and liability characteristics for LLCs?
Is state registered and combines advantages of the LLC with the flow-through tax treatment of other forms. File their taxes most commonly as either a partnership or S Corp.
What are the different kinds of partnerships?
General partnerships - partners are each generally liable for the obligations of the partnership.
Limited partnerships - by law, must include one general partner and one limited partner. The general partner has unlimited general liability, while the liability of the limited partner is restricted to only the investment in the partnership
Family limited partnerships (FLPs) - the partnership exists between family members and is generally used for estate planning purposes to permit gifting of limited partnership interest in a family business at a substantial valuation discount. The general partner is typically a parent, who contributes property and manages the business. They will then make gifts of limited partnership interests to children / other family members.
