Personal Financial Statements (Preparation and Analysis) 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

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

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

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

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

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

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

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

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 Target of three to six months

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%

Savings Ratios Personal savings and employer contributions to annual gross income Target of ≤10% (age dependent) Discretionary cash flow + savings to gross income Target of >10%

Investment assets to annual gross income 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