1. Topic 2
Financial Statements

2. Topic 2: Financial Statements
Learning Objectives
(a) Construct statements of financial positions and cash-flow statements as applied to clients consistent with sound personal accounting standards.
(b) Evaluate client financial statements using ratios and growth rates and by comparing them to relevant norms.

3. Topic 2: Financial Statements
Personal
Statement of financial position
Statement of cash flow
Pro forma statements
Business
Balance Sheet
Income Statement

4. Topic 2: Statement of Financial Position
Also called balance sheet
A snapshot of the client’s financial position as of a given date
For example as of December 31, 20XX
Components
Assets
Liabilities
Net worth
Assets = Liabilities + Net worth

5. Topic 2: Evaluating the Statement of Financial Position
Used to:
Understand how various transactions affect the client’s net worth
Analyze distribution (types and amounts) of assets and liabilities
Analyze the amount and make-up of net worth

6. Topic 2: Statement of Cash Flow
Presents the cash receipts and cash disbursements over a period of time
For example
For the year ended December 31, 20XX
For the six months ended December 31, 20XX
Some disbursements are fixed, others are discretionary

7. Topic 2: Pro Forma Statements
A projection of cash flow numbers to determine whether and how the client can continue to reach the financial objectives from the existing financial information that was previously relied upon
Can be used in used in step 4 of the planning process in conducting scenario analysis to communicate to the client what the results might look like under various circumstances

8. Topic 2, Part 2: Ratio Analysis
Used to identify strengths and weaknesses of the current financial position
Liquidity ratios
Savings ratios
Solvency and debt ratios
Asset allocation ratios

9. Topic 2, Part2: Liquidity Ratios
A ratio of total current assets to total current debts that is below 1.0 suggests that the client cannot cover the full year’s debt obligations with available liquid assets.
The actual acceptable value will vary based on cash flow

10. Topic 2, Part2: Liquidity Ratios
Another liquidity ratio used to measure whether the client has an adequate emergency fund that can be drawn upon quickly if needed to cover major unexpected adverse events (or to take advantage of major unexpected opportunities)
Many planners recommend an emergency fund equal to 3 to 6 months of the client’s income, excluding income taxes and savings

11. Topic 2, Part2: Liquidity Ratios
The third ratio is a measure of how much the client owes on the assets that he/she owns
Greater than 1 indicates that the client is technically insolvent. This does not necessarily lead to bankruptcy if cash flows are adequate

12. Topic 2, Part2: Savings Ratios
The savings ratio examines the percentage of the client’s gross income that goes to current consumption and the percentage that goes to saving and investing
Many planners recommend that no more than 90% of income should go to current consumption (i.e., the savings ratio should be at least 10%)

13. Topic 2, Part2: Solvency and Debt Ratios
In simplified terms, the solvency ratio is a measure of how far asset values can decline before wiping out all of the net worth
For example, a solvency ratio of .82 would indicate that assets could decline by 82% before net worth would be reduced to zero

14. Topic 2, Part2: Solvency and Debt Ratios
The consumer debt ratio (non-mortgage debt ratio) measures the amount of net income that is used to service non-mortgage debts
Should generally be no more than 10% to 15%
A ratio above 20% is considered a danger signal, and the client should be counseled regarding consumer spending

15. Topic 2, Part2: Solvency and Debt Ratios
The ratio of monthly housing payments to gross income looks at monthly payments for principal, interest, taxes, and insurance (PITI) in relation to gross income
General guideline is that the PITI payments should not exceed 28% of gross income AND should not exceed one week’s after-tax income

16. Topic 2, Part2: Solvency and Debt Ratios
The debt service ratio is total monthly debt payments (PITI + consumer debt) divided by monthly gross income
This ratio should not exceed 36% of gross income
A ratio above 45% is generally considered a dangerous level

17. Topic 2, Part2: Asset Allocation Ratios
The investment assets-to-net worth ratio is a measure of how well the client is doing at accumulating capital
Appropriate measure will vary throughout the phases of a client’s financial life
Should generally be approaching 50% or higher as retirement grows nearer
Younger clients who are just beginning to invest may have ratios well below 20%, but should see the number growing as they save and invest throughout their working years.

18. End of Topic 2