Fundamentals Chapter 4 Recap: “Personal Financial Statements: Preparation and Analysis”

Chapter Recaps: my notes to chapters of the financial planning coursework material through New York University’s CFP^® Program (in conjunction with Dalton Education).

Chapter 4: Personal Financial Statements: Preparation and Analysis

Introduction
1. Personal financial statements essential for evaluating and reviewing client’s financial position and performance.
2. Use statements to engage in financial statement analysis – the process of calculating financial ratios and comparing the actual ratios to industry established benchmarks.
3. Clients rarely have well-prepared statements.
4. Two principal financial statements:
  1. The Balance Sheet (B/S), aka, the “Statement of Financial Position” or a “Statement of Assets, Liabilities, and Net Worth.”
  2. The Income Statement (I/S), aka, a “Statement of Income and Expenses.”
5. Two supplementary financial statements (rarely prepared in practice):
  1. The Statement of Net Worth (NW).
  2. The Cash Flow Statement.
Balance Sheet (Statement of Financial Position)
1. Balance Sheet = snapshot of the client’s assets, liabilities, and NW as of a stated date.
2. Assets:
  1. Property owned or partially-owned by client and stated at fair value.
  2. Classified into one of three categories:
    1. Cash & Cash Equivalents (Current Assets):
      1. Highly liquid, meaning they are cash or able to be converted into cash within the next 12 months (with little to no price concession from their current value.)
      2. Examples: cash, checking, money market, CD.
        
        Also, includes any assets client expects to convert to cash within 1 year.
    2. Investment Assets
      1. Appreciating assets OR assets being held to accomplish one or more financial goals.
      2. Examples: stocks, bonds, mutual funds, retirement accounts, education funds, cash value in life insurance, business ownership interests, and the vested portion of any pension plan.
        
        Private businesses are typically difficult to value. Some important planning questions:
        
        Does the valuation come from a valuation professional?
        
        How current is the valuation?
        
        Is the goodwill associated with the business or the owner?
        
        Will the business be sold to fund retirement?
      3. Stated on B/S at their current fair market value.
    3. Personal Use Assets
      1. Assets used to maintain the client’s lifestyle.
      2. Examples: personal residence, car, furniture, boat, clothing, vacation homes, collectibles (art/antiques), and electronics (TV, stereo, iPod, etc.).
      3. Value usually determined by client (versus appraisal). Better to be conservative.
        
        Less important than value of investment assets.
3. Liabilities:
  1. Financial obligations the client owes to creditors.
  2. Classified according to the timing when they are due:
    1. Current liabilities = due or expected to be paid within the next 12 months.
      1. Examples:
        
        Electric, gas, water, garbage bills incurred but not yet paid.
        
        Principal portion of any debt obligations due within the next 12 months (mortgage and auto loan).
        
        Unpaid credit card bills, outstanding medical expenses, unpaid taxes.
    2. Long-term Liabilities = financial obligations owed and due and expected to be paid beyond the next 12 months. (usually are the result of major financial purchases.
      1. Examples:
        
        Primary residence loans.
        
        Vacation home loans.
        
        Car loans.
        
        Student loans.
        
        Any other type of loan or promissory note.
  3. Note: current portion of the liability should be reported separately from the LT portion (allows planner to compare current assets vs. current liabilities).
4. Balance Sheet Equation
  1. Assets = L + NW
  2. Know the impact of transactions (can see page 138 and 139).
5. Net Worth:
  1. The total amount of equity (assets – liabilities) the client has accumulated as of the B/S date.
  2. Can be negative:
    1. Example: when a client buys a home, but then the home value declines below the outstanding debt of the home.
  1. Valuing Assets & Liabilities:
    1. Assets = fair market value.
    2. Liabilities = current outstanding principal balance a/o the balance sheet date.
6. Sources of Information:
  1. Need source documents form client to properly value Assets & Liabilities. Source docs include: bank and brokerage statements, loan amortization schedules, and tax returns.
7. Account Ownership:
  1. Important to include how an asset or liability is titled (owned) in the asset or liability line item on the B/S.
  2. Most common forms of ownership (covered more in Chapter 14): Fee Simple, tenancy in Common, Joint Tenancy with Right of Survivorship (JTWROS), and Community Property.
    1. Fee Simple = complete ownership of property by one individual who has all ownership rights (including right to use, sell, gift, alienate, convey, or bequeath). Example: car.
      1. When husband or wife owns an asset solely: (H) designates husband and (W) wife.
    2. Tenancy in common = property interest held by 2 or more related or unrelated people.
      1. Each person referred to as a “tenant in common” and is most common joint ownership between nonspouses. (Each has an undivided, but not necessarily equal, interest in the entire property).
    3. Joint Tenancy with Right of Survivorship (JTWROS).
      1. Joint tenancy = an interest in property held by 2 or more related or unrelated people called “joint tenants.” Each holds an undivided, equal interest in the whole property.
      2. Right of Survivorship – at death of first joint tenant, the decedent’s interest transfers to the other joint tenants outside of the probate process according to state titling law.
        
        Probate = the process where a probate court retitles assets and allows creditors to be heard/stake a claim to any assets to satisfy outstanding debts.
      3. (Because of this right of surviorship, joint tenancy is often called joint tenancy with right of survivorship.)
    4. Tenancy by the entirety = similar to JTWROS as property ownership automatically transferred to the surviving spouse on death. and each own an undivided interest. However, the ownership cannot be severed without the other spouse’s consent.
    5. Community property = a civil law statutory regime where married individuals own an equal undivided interest in all accumulated during the marriage.
      1. Income is considered community property.
      2. Property acquired before marriage and received by gift or inheritance after stays separate property.
      3. Any property commingled with community property is often assumed to be community, though.
      4. Usually doesn’t automatically have an automatic right of survivorship feature.
  3. Property owned JTWROS and tenancy by the entirety avoids probate and the decedent’s interest transfers automatically.
  4. Property owned in a revocable trust would be listed on the B/S as trust assets.
  1. Limitations on usefulness of B/S:
    1. Doesn’t explain:
      1. Why or how an asset increased. (Did client buy more or did asset appreciate?)
      2. Why or how an asset or liability appears. (Did client acquire asset or inherit?)
      3. Changes in Net Worth. (Added savings, inherited asset, asset appreciated, or retired debt?).
  2. Footnotes can explain some things and planners should always read:
    1. Footnotes can provide information on how the asset or liability is owned, purchase price of an asset, the date asset/liability acquired, valuation methodologies, and more.
Statement of Income and Expenses
1. Income Statement definition:
  1. All income earned or expected to be earned, less all expenses incurred or expected to be incurred during the time period being covered (usually yearly, though can be prepared for a month or quarter).
2. Income (examples):
  1. Salary, interest, dividends, business income, pension, retirement account withdrawal, and alimony received.
3. Savings:
  1. Along with expenses, savings must be reported on the I/S.
  2. Example saving contributions (to the following accounts):
    1. 401 (k) plan
    2. 403 (b) plan
    3. 457 (b) plan
    4. IRA (Traditional or Roth)
    5. Education Savings
    6. Any other type of savings account.
    7. Reinvested dividends, interest or capital gains.
4. Expenses:
  1. Recurring = those paid regularly during the time period. Examples: Mortgage Principal & Interest, Utilities, Taxes, Insurance, Telephone, Water, Cable/Satellite, Internet & Cell phone.
  2. Variable and Fixed:
    1. Fixed: Less discretion over fixed expenses in the short-term. Examples: Mortgage/car/boat/student loan payments, property taxes, insurance premiums, withheld federal and state income taxes, and social security payments withheld.
    2. Variable: more discretionary than fixed over the ST. Presents an opportunity for saving: entertainment, vacation, travel, and potentially charitable.
5. Notable Accounting conventions with the I/S:
  1. Non-recurring cash transactions are not included. Examples: sale of stock, employer’s retirement plan contribution, giving/receiving a cash gift, or an inheritance.
  2. Non-recurring non-cash changes in B/S are not reported on I/S. Examples: gifting/receiving stock and gifting/receiving personal use assets.
    1. These are only reported in a statement of changes in Net Worth.
6. Net Discretionary Cash Flows
  1. Definition: the amount of CF available after all savings, expenses, and taxes are paid, aka:
    1. Net Discretionary Cash Flow = Income – Savings – Expenses – Taxes
  2. Can be positive, negative, or zero:
    1. Positive = income greater than savings, expenses, and taxes. An opportunity for: additional savings, retire debt, or buy more comprehensive insurance.
    2. Negative = income less than savings, expenses, and taxes. Requires taking steps to reduce expenses, taxes, or savings. Ultimately negative discretionary cash flows can result in financial disaster/bankruptcy.
7. Sources of Information:
  1. Initially, won’t have, but subsequent meetings should get:
    1. W-2s (reports income and deferred retirement savings)
    2. Credit card statements (year-end very informative)
    3. Billing statements (utilities, telephone, internet, satellite)
    4. Bank statements (especially with bill payments)
    5. Federal & state income statements
  2. May need to back into total spent on savings, expenses, and taxes if client doesn’t have all statements (frequently the case).
8. Projected Income Statements
  1. Helpful with an expected lifestyle change (e.g., children go to college or client retires).
  2. Can help identify cash shortfalls or excessive net-discretionary cash flows.
Statement of Net Worth
1. Purpose: explains changes in net worth between two balance sheets by reporting financial transactions not reported on the I/S or Cash Flow statement. Essentially, it explains changes in net worth that do not affect cash.
2. Example transactions:
  1. Giving or receiving property other than cash.
  2. Inheriting property other than cash.
  3. Employer contributions or matches to retirement savings accounts.
  4. Appreciation or depreciation of assets.
3. Formula:
  1. Beginning Balance of Net Worth + additions (appreciation of assets, receiving a gift or inheritance) – subtractions (giving gifts other than cash).
4. In practice:
  1. Few clients have, and very few planners actually prepare.
Cash Flow Statement
1. Purpose: explains how cash and cash equivalents were used or generated between two balance sheets.
  1. It’s a supplementary statement of non-recurring transactions not reported on I/S. (The I/S only captures monthly or annually recurring income and expenses.
2. Major sections are nonrecurring cash transactions used or generated from: Investment activities an Financing activities.
  1. Investing:
    1. Purchase/sale of a personal use asset (car or house).
    2. Purchase/sale of an investment asset (mutual fund or stock)
    3. Contributing to a retirement or education savings account.
    4. Receiving/making gifts of cash.
    5. Cash inheritances.
  2. Financing:
    1. Principal reduction of any loans.
    2. Any new loans.
    3. Paying off credit card balances.
Forecasting
1. Introduction section:
  1. Planner should prepare forecasted B/S and I/S for next year, 3 years, and 5 years. Should reflect:
    1. Implementation of recommendations (example: increasing 401(k) savings).
    2. Inflation adjustment for expenses: insurance premiums, utilities, gasoline, and any variable interest rate loans.
    3. Inflation adjustment for income.
    4. Other adjustments (any major changes to income like retirement, retiring debt, paying for college education expenses, borrowing money for car, house, boat, college education, etc.).
  2. Once have forecasted statements, can conduct financial statement analysis (discussed below).
2. Importance of Budgeting
  1. Purpose: evaluate client’s spending and savings behavior and establish a spending and savings plan to help client achieve financial goals.
    1. Clients are usually resistant to preparing or using a budget because haven’t been successful in past following budgets.
  2. Tips: 3 important tips in preparing and using a budget:
    1. Be realistic with spending behavior.
    2. Use a “miscellaneous” and “unforeseen expenses” line items. Misc. = holiday gifts, car/house repairs, traffic tickets, etc.
    3. It’s going to take practice.
  3. Steps to Budgeting:
    1. Establish goals.
    2. Determine client’s income for a time period.
    3. Determine expenses, both fixed and variable.
    4. Determine whether the net discretionary CF is positive or negative.
    5. Present expenses as a percentage of income for the time period being presented.
      1. Generally, should be level or decreasing over time.
  4. Follow the I/S categories:
    1. Income = all salary, wages, dividends, royalties, interest and business income.
    2. Savings:
      1. Retirement benchmark: 10-13% of gross pay. Includes any employer match or contribution.
      2. If Education goal = add an additional 3-6% percent of savings.
    3. Debt:
      1. Total debt should be <= 36% of gross pay. Housing costs <= 28% of gross pay.
    4. Living Expenses:
      1. 50% or less.
      2. Includes all discretionary, plus non-discretionary and housing costs.
        
        Discretionary = entertainment, vacations, clothing, cable TV, etc.
        
        Non-discretionary = food, utilities, phone, etc.
    5. Insurance:
      1. Premiums for all insurance.
      2. Should be 5-9% of gross pay.
    6. Taxes:
      1. Federal, state, and local income taxes and Social Security: 20-25%.
3. Financial Statement Analysis
  1. Critical part of the “Analyze and Evaluate” step of the financial planning process.
  2. Accomplished with vertical analysis, horizontal analysis, and ratio analysis.
  3. Trends help planner see if client is making adequate progress towards financial goals. Also, help see important information that may not necessarily have been communicated by client.
  4. Limitations: a historical perspective and not predictive of the future.
4. Comparative Financial Statement Tools
  1. Vertical Analysis
    1. Listing each line item on the I/S as a percentage of total income and presenting each line item on the B/S as a percentage of total assets.
    2. Aka, a common size analysis.
    3. Helps to compare trends for each percentage over time.
  2. Horizontal Analysis
    1. Listing each item as a percentage of a base year to see a trend over time.
5. Ratio Analysis:
  1. This section is more in-depth coverage of Chapter 3’s discussion of financial statement and ratio analysis.
  2. Ratio analysis = process of calculating key financial ratios for a client, comparing those metrics to industry benchmarks, and then evaluating possible deficiencies.
    1. It’s both an art and a science:
      1. Science = calculating the ratio.
      2. Art = deriving meaning/insight form the ratio.
Financial Statement Analysis – The Bowdens
1. See pages 157 to 177.
Limitations of Financial Statement Analysis
1. Estimating Fair Market Value
  1. Personal use assets are estimated. If client owns a small business, it’s likely planner will need to estimate its value. Must be conservative so financial goal isn’t jeopardized from overstating the value.
2. Inflation
  1. Makes it difficult to compare financial statements over multiple periods.
    1. Planner should adjust investment returns to determine a real rate of return. Also adjust income and savings into real dollars.
3. Hard-to-value Assets
  1. Collectibles and private business interests. If asset is used to fund a financial goal, important to use an appraiser.
4. Liquidity of Certain Assets
  1. Certain assets, like small business or collectibles may be difficult to sell. Planner should be careful planning timing of sale if using to fund a financial goal.
5. Uncertain Returns
  1. Benchmarks are based on historical asset class returns, but evolving markets may produce higher or lower returns.
6. Sensitivity Analysis
  1. Conducting Sensitivity analysis: the process of changing key variables in planning assumptions to determine the overall impact of those changes on the plan (exploring “what if” scenarios). Can be external assumptions (inflation, tax rate) or internal (retirement age, savings rate).
  2. Monte Carlo Analysis – a mathematical simulation to determine the probability of achieving a given outcome.
    1. Example: can be used to estimate the probability of a retirement portfolio running out of money.

The Advisor Project

Fundamentals Chapter 4 Recap: “Personal Financial Statements: Preparation and Analysis”

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