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Chapter 4. Personal Financial Statements (Preparation and Analysis). Financial Statements Provide Information. Financial resources available to client How resources were acquired What the client has accomplished financially using these resources. Personal Financial Statements.
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Chapter 4 • Personal Financial Statements • (Preparation and Analysis)
Financial Statements Provide Information • Financial resources available to client • How resources were acquired • What the client has accomplished financially using these resources
Personal Financial Statements • Statement of financial position • Personal statement of cash flows • Statement of changes in net worth
Use of Financial Statements • By clients to benchmark goal achievement • By planners to help clients set financial direction • By creditors and lenders to make decisions to extend, continue, or call indebtedness
Statement of Financial Position • Assets • Liabilities • Net worth
Asset Categories and Classifications • Current assets • Cash and cash equivalents • Liquid—easily converted to cash • Convert to cash within a year • Investment assets • Held for growth or income • Personal-use assets • Long-lived assets • Used to maintain quality of life
Liability Categories and Classifications • Current liabilities • Credit card debt and unpaid bills • Long-term liabilities • Debts of larger assets
Valuation of Assets and Liabilities • Assets valued at fair market value • Liabilities represent principal owed
Nelson Statement of Financial Position as of 01/01/2011(cont) • Notes to financial statements: • Assets are stated at fair market value. • The ABC stock was inherited from Dana’s aunt on November 15, 2004. • Her aunt originally paid $20,000 for it on October 31, 2004. • The fair market value at the aunt’s death was $12,000. • Liabilities are stated at principal only. • H= husband; W = wife; JT = joint tenancy
Nelson Statement of Financial Position as of 12/31/2009(cont) • Notes to financial statements: • Assets are stated at fair market value. • The ABC stock was inherited from Dana’s aunt on November 15, 2004. • Her aunt originally paid $20,000 for it on October 31, 2004. • The fair market value at the aunt’s death was $12,000. • Liabilities are stated at principal only. • H= husband; W = wife; JT = joint tenancy
Personal Statement of Cash Flows • Summary of client’s income and expenses over time, usually one year • May focus on realized transactions, and if so, helps compare to budgeted financial goals • May be prepared in advance and used for budgeting or projections
Personal Statement of Cash Flows Terms • Income • Employment • Investment • Other • Savings • Expenses • Fixed • Variable • Discretionary
Statement of Changes in Net Worth • Summarizes non-cash flow changes in net worth not recorded on the income statement
Statement of Changes in Net Worth Transactions • Changes in value of assets resulting from appreciation or depreciation • If an asset other than cash is exchanged for other assets • If assets other than cash are received by gift or inheritance • If assets other than cash are given to charities or noncharitable donees
Financial Analysis of Personal Financial Statements • Keys to ratio analysis: • Does the ratio answer the question asked? • Is there some standard or benchmark to determine whether the result is appropriate for this particular client?
Ratio Analysis—The Objective • Objective of ratio analysis is twofold: • To gain additional insight into the financial situation and behavior of the client • To generate questions for the client to further gain such insight
Types of Ratio Analysis • Liquidity ratios—emergency fund ratio and current ratio • Debt ratios and debt analysis—total debt to net worth, long-term debt to net worth, total debt to total assets, long-term debt to total assets, consumer debt ratio—Non-housing monthly debt service to monthly gross income, monthly housing costs to monthly gross income, monthly housing costs and other debt repayments to monthly gross income • Performance ratios—savings ratio, discretionary cash flows plus savings to gross income, income on investments, rate of return on investments and investment assets to gross income
Target of three to six months Emergency Fund Ratio
Current Ratio Target of 1.0 to 2.0
Lending Ratios • Monthly housing costs (mortgage payment + property tax + homeowners insurance) to monthly gross income • Target of ≤28% • Monthly housing and other debt repayments to monthly gross income • Target of ≤36%
Discretionary cash flow + savings to gross income Savings Ratios Personal savings and employer contributions to annual gross income Target of ≤10% (age dependent) Target of >10%
Investment Ratios Target of 9−12% Investment assets to annual gross income
Vertical and Growth Analysis • Vertical analysis: • Statement of financial position—each item presented as a percentage of total assets • Personal statement of cash flows—each item presented as a percentage of total income • Growth analysis: • Calculates the growth rate of certain financial variables over time using time value of money tools
Limitations of Financial Statement Analysis • Inflation • Use of estimates • Few benchmarks for individuals
Sensitivity Analysis and Risk Analysis • Sensitivity analysis allows manipulation of input variables by small increments to determine the effect on the ratio • Risk analysis examines the uncertainty of cash flows to the individual • Business or investment risk • Financial risk
Budgeting • Process of projecting, monitoring, adjusting, and controlling future income and expenditures • Savings and consumption habits
Debt Management • Home mortgages • Fixed-rate mortgages • Variable-rate mortgages or adjustable-rate mortgages (ARMs) • Balloon mortgages
