Personal Financial Statements (Preparation and Analysis) Chapter 4 Personal Financial Statements (Preparation and Analysis) Chapter 4: Personal Financial Statements

Financial Statements Provide Information About: Financial resources available to client How resources were acquired What the client has accomplished financially utilizing these resources Chapter 4: Personal Financial Statements

Personal Financial Statements Balance Sheet Income Statement Statement of Changes in Net Worth Chapter 4: Personal Financial Statements

Financial Statements are Used: By clients to benchmark goal achievement By planners to help clients set financial direction By creditors & lenders to make decisions to extend, continue, or call indebtedness Chapter 4: Personal Financial Statements

Balance Sheet Terms Asset Liability Net Worth Chapter 4: Personal Financial Statements

Asset Categories & Classifications 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 Chapter 4: Personal Financial Statements

Liability Categories & Classifications Current Liabilities Credit card debt & unpaid bills Long-Term Liabilities Debts of larger assets Chapter 4: Personal Financial Statements

Valuation of Assets & Liabilities Assets valued at FMV Liabilities represent principal owed Chapter 4: Personal Financial Statements

Sample Balance Sheet Chapter 4: Personal Financial Statements

The Income and Expense Statement Summary of client’s income and expenses over a period of 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 Chapter 4: Personal Financial Statements

Income Statement Terms Employment Investment Other Savings Expenses Fixed Variable Discretionary Chapter 4: Personal Financial Statements

Sample Income Statement Chapter 4: Personal Financial Statements

The Statement of Changes in Net Worth Summarizes noncash flow changes in net worth not recorded on the income statement. Chapter 4: Personal Financial Statements

Statement of Changes in Net Worth Transactions Changes in value for assets due to appreciation or depreciation If an asset other than cash is exchanged for some 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 Chapter 4: Personal Financial Statements

Sample Statement of Changes in Net Worth Chapter 4: Personal Financial Statements

Ratio Analysis The key to ratio analysis is: Does the ratio get to the answer for the question asked? Is there some standard or benchmark to determine whether the result is appropriate for this particular client? Chapter 4: Personal Financial Statements

Ratio Analysis—The Objective The 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 answer to further gain such insight Chapter 4: Personal Financial Statements

Types of Ratio Analysis Liquidity ratios – emergency fund ratio and current ratio Debt ratios – total debt to net worth, long-term debt to net worth, debt to total assets, long-term debt to total assets, housing costs to gross income, housing and debt payments to gross income Performance ratios – savings ratios and investment performance ratios Chapter 4: Personal Financial Statements

Emergency Fund Ratio EFR = Current Assets Monthly Nondiscretionary Expenses Target of 3 to 6 months Chapter 4: Personal Financial Statements

Current Ratio CR = Current Assets Current Liabilities Target of 1.0 to 2.0 Chapter 4: Personal Financial Statements

Lending Ratios Housing Costs (Mortgage payment + Property tax + Homeowners insurance) to Gross Income Target of ≤ 28% Housing and Debt Payments (i.e. credit card, auto loan) to Gross Income Target of ≤ 36% Chapter 4: Personal Financial Statements

Savings Ratios Rate of Savings = Annual Savings Annual Gross Income Target of ≥ 10% (age dependent) Discretionary Cash Flow + Savings to Gross Income Target of ≥ 10% Chapter 4: Personal Financial Statements

Investment Ratios Income on Investments = Income from Investments Average Invested Assets ROI = EI – BI – Additional Investments Target of 9 to 12% Investment Assets to Gross Income Chapter 4: Personal Financial Statements

Vertical & Growth Analysis Vertical analysis: Balance sheet – each item presented as a percent of total assets Income statement – each item presented as a percent of total income Growth analysis: Calculates the growth rate of certain financial variables over time using TVM tools Chapter 4: Personal Financial Statements

Limitations of Financial Statement Analysis Inflation Use of estimates Few benchmarks for individuals Chapter 4: Personal Financial Statements

Sensitivity Analysis & Risk Analysis Sensitivity analysis allows manipulation of input variables by small increments to determine the impact on the ratio Risk analysis examines the uncertainty of cash flows to the individual Business or investment risk Financial risk Chapter 4: Personal Financial Statements

Budgeting A process of projecting, monitoring, adjusting and controlling future income and expenditures. Savings and Consumption Habits Chapter 4: Personal Financial Statements

Debt Management Home Mortgages Fixed-Rule Mortgages Variable-Rate Mortgages or Adjustable-Rate Mortgages (ARMs) Balloon Mortgages Chapter 4: Personal Financial Statements