Topic 2

Financial Statements

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.

Topic 2: Financial Statements

• Personal – Statement of financial position – Statement of cash flow – Pro forma statements

• Business– Balance Sheet– Income Statement– Pro forma statements

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

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

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

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

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

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

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AssetsCurrent50.25.

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

)63(50.25. monthstotoIncomeNetAnnual

AssetsCurrent

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

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DebtTotal

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%)

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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

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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

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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

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PaymentsPITI '%28

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

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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.

End of Topic 2