Chapter 3: Financial Statements and Cash Flow Management

What is the formula for calculating Net Worth?

Net Worth = Assets - Liabilities

What is the formula for calculating Assets?

Assets = Liabilities + Net Worth

What is the formula for calculating Liabilities?

Liabilities = Assets - Net Worth

During a 12-month period, Savannah Saver tracks a $100,000 increase in Total Assets and a $110,000 increase in Net Worth.

What was the exact dollar impact and direction of change on her Total Liabilities?

Liabilities decreased by $10,000.

• The Case Study Context: This usually happens when a client pays down debt using active cash flow (income) rather than just liquidating assets to pay it off.

When a question asks about the amount of client savings, always assume that any funds not allocated to expenses will be ______.

Savings

When analyzing a client's Cash Flow Statement, any surplus income remaining after subtracting all fixed, variable, and tax outflows from total inflows is strictly categorized as:

Savings (or Net Cash Flow).

Exam Tip: On the CFP® exam, unless explicitly stated otherwise, assume all unallocated surplus funds are directed to savings/capital accumulation.

Jack and Pat Spratt are reviewing their annual household financial metrics with their planner. They provide the following cash flow data for the prior 12-month period:

• Total Gross Inflows: $120,000

• Total Fixed Outflows: $25,000 (includes $10,000 mortgage payments)

• Total Variable Outflows: $30,000

• Total Tax Outflows: $31,000 (includes income, FICA, and self-employment taxes)

Assuming all unallocated cash surplus is captured at year-end, what is the total amount available for the Spratts' Savings and Investments?

$34,000

To find the net cash flow available for savings/investments, utilize the foundational cash flow formula:

Total Inflows - Total Outflows = Savings / Surplus

$120,000 (Inflows) - [$25,000 (fixed) + $30,000 (variable) + $31,000 (taxes)] = Savings

$120,000 - $86,000 = $34,000

Stan and Fran Mann pay off their credit cards monthly from cash flow. They pay their mortgage payments from cash flow (yearly principal: $2,000; interest: $8,000; taxes: $1,000; insurance: $500). They save $50 per month in a money market account, and the interest earned and reinvested for the year is $100.

How much will the Manns’ net worth increase in the current year?

A. $2,000
B. $2,050
C. $2,600
D. $2,700

D. $2,700

Net worth increases when you either increase assets or decrease liabilities using cash flow. Look at the specific net-worth-building actions:

Debt Reduction (Decreasing Liabilities): Paying the mortgage principal reduces the loan balance, which directly increases net worth by $2,000. (Interest, taxes, and insurance are pure expenses and do not build equity).

• Asset Accumulation (Increasing Assets): Saving $50/month in the money market account adds $600 to assets.
  
  

• Reinvested Earnings (Increasing Assets): The $100 of interest is retained and reinvested inside the account, adding to assets.
  
  

• Total Increase: $2,000 + $600 + $100 = $2,700

Exam Tip: Paying off credit cards monthly out of cash flow does not alter net worth. It simultaneously decreases an asset (cash) and decreases a liability (card balance) by the exact same amount.

Upon what amount should the estimated value of a building owned wholly by a client in a personal financial statement be based?

A. The currently insured value

B. The basis of the asset, after adjustment for all straight-line and accelerated depreciation

C. The client’s estimate of the building’s current value after reading various multiple listings

D. The current replacement value of the asset

E. The value that a well-informed buyer is willing to pay a well-informed seller where neither is compelled to buy or sell

E. The value that a well-informed buyer is willing to pay a well-informed seller where neither is compelled to buy or sell

Danko-style Explanation:
Personal financial statements (Statements of Financial Position) strictly list assets at Fair Market Value (FMV). Option E provides the exact, textbook legal definition of FMV.

Which of the following items is not included on a client's Cash Flow Statement?

A. Taxes
B. Salaries
C. Auto note balance
D. Mortgage note payments
E. Interest income

C. Auto note balance

The auto note balance represents the total remaining debt owed. This is a liability, meaning it is strictly tracked on the Statement of Financial Position (Balance Sheet), not the Cash Flow Statement.

The other items are all proper cash movements:

• Inflows: Salaries (B) and Interest income (E).

• Outflows: Taxes (A) and Mortgage note payments (D).

Exam Tip: Do not confuse a debt's remaining principal balance (Balance Sheet liability) with the recurring payment made to service that debt (Cash Flow outflow).

What is the formula for the Capitalized Value of a business? (Not provided on the exam formula sheet!)

Capitalized Value = Annual Income / Capitalization Rate

What does Book Value represent?

The Corporate Balance Sheet

How do you determine a business’s net worth?

Book Value of Assets - Book Value of Liabilities = Business’s Net Worth

What is the formula for Capitalized Value of a business? (Not on formula sheet!)

Annual Income / Capitalization Rate

Conceptually, what does a business's Capitalization Rate represent?

The investor's required rate of return based on risk.

If a business's risk increases, what happens to its Cap Rate and Capitalized Value?

Cap Rate: Increases

Capitalized Value: Decreases

What is the Statement of Financial Position also known as?

The Balance Sheet

When gathering client data to prepare a Statement of Financial Position, which of the following items are required, and which one must be excluded?

• Cost or basis

• Encumbrances (liabilities)

• Budgeting / Spending patterns

• Savings and investment allocations

• Date assets were acquired

Included: Cost/basis, Encumbrances (liability), Savings/investment allocations, and Date acquired.

Excluded: Budgeting / Spending patterns.

The Rule: If it measures a flow of money over time, it belongs on the Cash Flow Statement, not the static snapshot of the Balance Sheet

In what scenarios should a 3 month emergency fund be recommended?

• Single with a second source of income

• Married, both work and have similar wages

• Married, only one spouse works, but has a second source of income

In what scenarios should a 6 month emergency fund be recommended?

• Single wage earner

• Married, only one spouse works

If your client is a single wage earner, how long of an emergency fund should you typically recommend?

6 months

If your client is Single with a second source of income, how long of an emergency fund should you typically recommend?

3 months

If your client is Married and only one spouse works, how long of an emergency fund should you typically recommend?

6 months

If your client is Married and both work and have similar wages, how long of an emergency fund should you typically recommend?

3 months

If your client is Married and only one spouse works, but has a second source of income, how long of an emergency fund should you typically recommend?

3 months

What are generally considered to be secondary sources of income?

• One party receives alimony

• One party is significantly wealthy

• One party has a large trust fund providing income and rights of withdrawal of principal

Terry and Tessie Tightwad, who are both office managers, have incurred fixed and variable expenses of $80,000 per year. Their combined earned income is $120,000. Tessie is the beneficiary of a small trust fund that produces marginal income. How much should they have in their emergency fund?

$20,000

Their combined earned income indicates they both work. Thus, three months of fixed and variable expenses are appropriate for their emergency fund.

Which of the following investment vehicles would be most appropriate for an emergency fund for a family with $20,000 a year in discretionary income?

I. A balanced mutual fund

II. A line of credit

III. Money market mutual funds

IV. Laddered CDs to mature every 6 months

Money market mutual funds & Laddered CDs to mature every 6 months

The investment instruments chosen for an emergency fund should be safe and liquid. Other examples of appropriate investments include savings accounts, shortterm CDs, T-bills, and even laddered CDs. While a line of credit may produce cash in a pinch, it is not an investment.

What does the acronym PITI strictly stand for, and how does the formula for the Front-End Housing Ratio differ from that strict acronym?

• PITI strictly stands for: Principal, Interest, Taxes, and Insurance.
  
  

• The Front-End Ratio Formula is:
  
  Front-End Ratio = PITI + HOA fees / Gross Monthly Income

Housing expenses (PITI or rent) should reflect ≤ (less than or equal to) __% of _____ (net or gross) income?

(most tested)

28% & gross income

Total recurring monthly debt obligations (PITI + consumer debt minimums) should reflect ≤ __% of ___ (net or gross) income?

(maybe tested)

36% & gross income (The Back-End Ratio)

Consumer Debt should reflect ≤ __% of net income (probably not tested)

20%

What are the standard financial planning benchmarks and income bases (Gross vs. Net) for the following three metrics?

1. Front-End Ratio (Housing)
   
   

2. Back-End Ratio (Total Debt)
   
   

3. Consumer Debt Ratio (Non-Housing)

1. Front-End: ≤ 28% of Gross Income (PITI + HOA)
   
   

2. Back-End: ≤ 36% of Gross Income (PITI + HOA + Consumer minimums)
   
   

3. Consumer Debt: ≤ 20% of Net Income (Consumer minimums only)

When calculating gross income for housing or debt-to-income ratios, should you subtract a client's elective deferrals to retirement plans (such as a 401(k) or Roth IRA)?

No. Do not subtract them.

The Rule: Gross income means total compensation before any pre-tax or post-tax retirement contributions are deducted.

Example: If a client earns $40,000 and defers 5% ($2,000) to a 401(k), their gross monthly income base is still calculated using $40,000 (or $3,333.33/month), not $38,000.

A couple has a $240,000 gross annual income and pays a combined $17,000 annually for mortgage principal, interest, property taxes, and homeowners insurance (PITI).

What is their exact housing expense ratio, and does it meet the standard benchmark?

7.08% ($17,000 / $240,000)

Benchmark Status: Yes, it is well below the maximum recommended benchmark of 28%.

Bob earns $40,000 in salary and contributes 5% (or $2,000) to his 401(k). What is Bob's annual gross income?

$40,000

Explanation: When calculating gross income, include elective deferrals to retirement plans. Do not subtract them.

What is the Current Ratio formula?

Current Ratio = Current Assets / Current Liabilities

In regard to the Current Ratio, what assets & liabilities are considered Current Assets & Current Liabilities?

Current Assets:

• Cash & cash equivalents

• Marketable securities

• Accounts receivable

• Inventory

Current Liabilities:

• Cash owed

• Accounts payable

• Credit Card debt

• Taxes payable

True or False: Credit card outstanding balances, unpaid medical bills, and taxes payable this year are all included in the denominator when calculating a family's Current Ratio.

• True.
  
  

  • The Reason: In personal finance, Current Liabilities consist of any household debt obligations or unpaid bills due within 12 months.
    
    

  • Note: Corporate terms like "Accounts Payable" are swapped for "Unpaid Bills" or "Short-Term Consumer Debt" on a retail client's statement.

Should you include a client's credit card debt as a current liability if the case study states they pay off the balance in full every single month?

Yes.

• The Rule: Always include credit card debt as a current liability, regardless of the client's monthly payoff habits. It represents an outstanding balance on the snapshot date.

When do you include taxes payable as a current liability on the Statement of Financial Position?

Only when explicitly stated.

• The Rule: Only include taxes payable if the material explicitly indicates that the taxes are due or directly labels them as "payable." Do not assume or calculate projected taxes unless prompted.

When calculating current liabilities, under what condition do you include a portion of the client's mortgage information?

Only when the data specifies the "current amount due."

• The Rule: Do not calculate the next 12 months of principal yourself. Only list a mortgage component under current liabilities if the case study explicitly provides the "current amount" of the mortgage due.

Skipper’s balance sheet reports that he has the following assets and liabilities:

• Checking account: $3,000

• Money market: $12,000

• 401(k) balance: $50,000

• Municipal bond: $20,000

• Credit card debt: $5,000

• Mortgage: $50,000
  
  

What is the current ratio for Skipper?

7

Explanation:

Current Ratio = Current Assets / Current Liabilities

Current Ratio = Checking + Money Market + Bond / Credit Cad debt

$3,000 + $12,000 + $20,000 / $5,000 = 7

Because the 401(k) is subject to ordinary income and a 10% penalty, it is usually not regarded as a marketable security due to taxation costs.

Which of the following would be the most effective method of implementing a savings plan?

• Pay all expenses first, including credit cards, then deposit the remainder into a money market account.
  
  

• Wait until the end of the month and see if any money remains after covering expenses.
  
  

• Deposit a specific amount from each paycheck into a savings or money market account.
  
  

• Provide the client with a one-year budget. Then see if the client can spend less than they take in.

Deposit a specific amount from each paycheck into a savings or money market account, or “Paying yourself first” is generally the best advice to succeed at saving.

If the current checking account balance exceeds the normal monthly expenses, what do you do when calculating the emergency fund balance?

Subtract one month of expenses.

Example:

• Money Market: $10,000

• Checking Account Balance: $7,250

• Monthly Expenses: $3,250

• Emergency Fund Balance: $7,250 − $3,250 = $4,250 + $10,000 = $14,250

If the normal monthly expenses exceed the funds in the checking account, what do you do when calculating the emergency fund balance?

Ignore the negative number (the deficit created).

or SIMPLY Ignore both numbers (expense and checking).

Example:

• Money Market: $10,000

• Checking Account Balance: $3,550

• Monthly Expenses: $5,000

• Emergency Fund Balance: $10,000 (Count the checking box as $0; do not subtract the $1,450 deficit from the money market).

Client has $5,000 in Checking, $7,000 in a Money Market Account, and monthly expenses of $6,417. What is the total dollar amount available in their emergency fund?

$7,000

• Checking Account: $5,000 is less than the monthly expenses ($6,417). It is completely locked up paying this month's bills. Count = $7,000
  
  

• Money Market Account: Pure, separate savings. Count = $7,000.
  
  

• Total: $0 + $7,000 = $7,000. Do not pool them together and subtract the monthly expenses from the combined amount ($12,000 - $6,417 = $5,583 is a classic distractor option!).

Why are Income and FICA taxes completely excluded from the emergency fund equation, while Property taxes are included?

Because of Income Disruption Mutual Dependency

• Income & FICA Taxes: Triggered strictly by income generation. If a client loses their job (the core emergency being tested), their earned income drops to $0, and their active tax liability automatically drops to $0. You don't need a reserve to replace a bill that disappears.
  
  

• Property Taxes & Insurance: Asset-based liabilities. They do not care if you lose your job; the bill remains exactly the same. They must be paid out of the fund to avoid tax liens and achieve the #1 goal: Asset Protection.