Chapter 4Personal Financial Statements

(Preparation and Analysis)

4-2

Financial Statements Provide Information

Financial resources available to client

How resources were acquired

What the client has accomplished financially using these resources

4-3

Personal Financial Statements

Statement of financial position

Personal statement of cash flows

Statement of changes in net worth

4-4

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

4-5

Statement of Financial Position

Assets

Liabilities

Net worth

4-6

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

4-7

Liability Categories and Classifications

Current liabilities• Credit card debt and unpaid bills

Long-term liabilities• Debts of larger assets

4-8

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

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 12/31/2011

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

4-13

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

4-14

Personal Statement of Cash Flows Terms

Income• Employment • Investment • Other

Savings

Expenses• Fixed• Variable• Discretionary

Nelson Personal Statement of Cash Flows 2011 (1 of 2)

Nelson Personal Statement of Cash Flows 2011

(2 of 2)

4-17

Statement of Changes in Net Worth

Summarizes non-cash flow changes in net worth not recorded on the income statement

4-18

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

Nelson Statement of Changes in Net Worth (1 of 2)

Nelson Statement of Changes in Net Worth (1 of 2)

4-21

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?

4-22

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

4-23

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

Emergency Fund Ratio

Target of three to six months

Current AssetsEFR=

Monthly Nondiscretionary Expenses

Current Ratio

Current AssetsCR=

Current Liabililties

Target of 1.0 to 2.0

4-26

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%

Savings Ratios

Discretionary cash flow + savings to gross income

Target of ≤10% (age dependent)

Target of >10%

Personal savings and employer contributions to annual gross income

Investment Ratios

Investment assets to annual gross income

Income from InvestmentsIncome on Investments =

Average Invested Assets

EI - BI - Additional InvestmentsROI =

Average Invested Assets

Target of 9−12%

4-29

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

4-30

Limitations of Financial Statement Analysis

Inflation

Use of estimates

Few benchmarks for individuals

4-31

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

4-32

Budgeting

Process of projecting, monitoring, adjusting, and controlling future income and expenditures

• Savings and consumption habits

4-33

Debt Management

Home mortgages• Fixed-rate mortgages• Variable-rate mortgages or adjustable-rate

mortgages (ARMs)• Balloon mortgages