Units 4 and 5

Personal Financial Statements

Tools used to capture and analyze an individual's financial position and performance.

Two Primary Personal Financial Statements

Balance Sheet and Statement of Income and Expenses.

Balance Sheet

Shows assets, liabilities, and net worth at a specific point in time.

Alternate Name for Balance Sheet

Statement of Financial Position.

Net Worth Formula

Assets - liabilities.

Cash and Cash Equivalents

Cash, checking, money market funds, and assets maturing within one year.

Investment Assets

Assets used to achieve client goals such as stocks, bonds, mutual funds, retirement accounts, and businesses.

Personal Use Assets

Assets used to maintain lifestyle such as homes, vehicles, furniture, boats, and clothing.

Examples of Current Liabilities

Credit card balances and unpaid bills.

Examples of Long-Term Liabilities

Mortgages, auto loans, and boat loans.

Effect of Purchasing an Asset with Debt

Usually no immediate change in net worth.

Example of No Net Worth Change

Buying a $100,000 home with $20,000 down and $80,000 mortgage.

Purchases that Immediately Decrease Net Worth

Food, vacations, and other consumption expenses.

Balance Sheet Limitation

Does not explain why assets or liabilities changed.

Does not explain how assets were acquired.

Cannot show changes over time without comparison periods.

Statement of Income and Expenses

Shows income, savings, and expenses over a period of time.

Income Examples

Salary, dividends, interest, pension income, business income.

Savings Examples

401(k), 403(b), 457(b), IRA, education savings contributions.

Expense Examples

Mortgage payments, taxes, insurance, utilities, internet, cell phone.

Income Statement Limitation

Only includes recurring income and expenses.

Does not include purchases or sales of assets.

Does not include gifts or inheritances.

Excludes employer retirement contributions.

Best Statement for Finding Spending Leaks

Statement of Income and Expenses.

Liquidity Ratio Category

Measures ability to meet short-term obligations.

Debt Ratio Category

Measures effectiveness of debt management.

Performance Ratio Category

Measures progress toward goals and investment performance.

Emergency Fund Ratio

Cash and cash equivalents divided by monthly nondiscretionary cash flows.

Emergency Fund Ratio Benchmark

3 to 6 months.

Purpose of Emergency Fund Ratio

Measures how long a client can cover essential expenses.

Nondiscretionary Expenses

Mortgage, food, utilities, insurance, transportation, loan payments.

Factors Affecting Emergency Fund Needs

Job specialization, disability elimination periods, family situation.

Current Ratio

Cash and cash equivalents divided by current liabilities.

Current Ratio Benchmark

1.0 to 2.0.

Purpose of Current Ratio

Measures ability to meet current liabilities immediately.

Low Current Ratio Warning

Potentially insufficient liquidity.

High Current Ratio Warning

Potentially inefficient use of assets.

Good Debt Characteristics

Low interest rate and economic benefits exceed payback period.

Good Debt Example

15-year mortgage on a long-life asset.

Student loans leading to high earning potential.

Reasonable Debt

Debt with likely positive returns but less certainty.

Reasonable Debt Example

30-year home mortgage.

Bad Debt Definition

Debt with high interest rates or repayment period longer than asset life.

Bad Debt Example

High-interest credit card debt.

72-month auto loan on a rapidly depreciating vehicle.

Debt-to-Total-Assets Ratio

Total debt divided by total assets.

Purpose of Debt-to-Total-Assets Ratio

Measures percentage of assets financed by creditors.

Debt-to-Total-Assets Ratio Trend

Tends to decline with age.

Housing Ratio 1 (Front-End Ratio)

Monthly housing costs divided by monthly gross income.

Housing Ratio 1 Benchmark

28% or less.

Housing Ratio 1 Includes

Principal, interest, taxes, and insurance (PITI).

Housing Ratio 1 Excludes

Utilities, maintenance, lawn care.

Housing Ratio 2 (Back-End Ratio)

Housing costs plus other debt payments divided by gross income.

Housing Ratio 2 Benchmark

36% or less.

Housing Ratio 2 Includes

Auto loans, student loans, credit cards, and recurring debt payments.

Housing Ratio 1 Purpose

Determines affordability of housing costs.

Housing Ratio 2 Purpose

Determines overall debt burden.

Debt Management Warning Sign

Housing Ratio 2 substantially above 36%.

Financial Security Ratio Purpose

Measures retirement preparedness and investment progress.

Investment Assets Include

Retirement accounts, stocks, bonds, mutual funds, businesses.

Age 25 IA/GP Benchmark

0.2:1.

Age 30 IA/GP Benchmark

0.6 to 0.8:1.

Age 35 IA/GP Benchmark

1.6 to 1.8:1.

Age 45 IA/GP Benchmark

3 to 4:1.

Age 55 IA/GP Benchmark

8 to 10:1.

Age 65 IA/GP Benchmark

16 to 20:1.

Investment Assets to Gross Pay Formula

(Investment Assets + Cash Equivalents) ÷ Gross Pay.

Return on Investment (ROI) Ratio

Measures return generated by invested assets.

ROI Formula

(Ending Balance − Beginning Balance − Savings) ÷ Beginning Balance.

ROI Benchmark

Generally 6% to 10%.

ROI Benchmark Depends On

Time horizon and risk tolerance.

Higher Equity Portfolio ROI Expectation

Approximately 8% to 10%.

Shorter Time Horizon ROI Expectation

Approximately 6% to 8%.

Return on Assets (ROA) Ratio

Measures return on total assets.

ROA Formula

(Ending Assets − Beginning Assets − Savings) ÷ Beginning Assets.

ROA Benchmark

Approximately 2% to 4%.

ROA Use

Captures growth across all assets.

ROA Limitation

Can be distorted by leveraged assets.

Horizontal Analysis

Compares changes over time.

Horizontal Analysis Method

Lists values as percentages of a base year.

Horizontal Analysis Purpose

Identifies trends across periods.

Vertical Analysis

Expresses items as a percentage of a total.

Vertical Analysis on Income Statement

Line items shown as a percentage of income.

Vertical Analysis on Balance Sheet

Line items shown as a percentage of total assets.

Vertical Analysis Purpose

Evaluates current allocation of resources.

Example of Vertical Analysis

Housing expense as a percent of total expenses.

Example of Horizontal Analysis

Change in housing expenses over several years.

Advantage of Ratio Analysis

Provides insight into strengths and weaknesses.

Purpose of Ratio Analysis

Generate insight and better client questions.

Science of Ratio Analysis

Calculating ratios accurately.

Art of Ratio Analysis

Interpreting meaning and implications.

Financial Statement Limitation

Historical information cannot predict future results.

Inflation distorts comparisons across time.

Asset values often require estimates.

Limited established benchmarks.

Use of Estimates Limitation

Net worth calculations often require estimated values.

Sensitivity Analysis

Tests changes in assumptions to evaluate outcomes.

Sensitivity Analysis Example

Changing inflation assumptions.

Changing savings rates.

Changing investment return assumptions.

Purpose of Sensitivity Analysis

Determines impact of changing assumptions.

Monte Carlo Analysis

Mathematical simulation that tests probability of outcomes.

Monte Carlo Analysis Purpose

Evaluates likelihood of success under many scenarios.

Monte Carlo Advantage

Models thousands of possible outcomes.

Monte Carlo Limitation

Highly sensitive to assumptions.

Cannot reliably model rare catastrophic events.

Garbage In, Garbage Out

Incorrect assumptions produce misleading results.

Black Swan Event

Rare but highly consequential event.

Black Swan Example

Disability of a client or family member.

Financial Statement Analysis Best Practice

Use with other planning approaches rather than alone.

Retirement Planning Assessment

Requires savings rate, asset accumulation, and investment performance analysis.