CHAPTER 3: FINANCIAL PLANNING

APPROACHES: ANALYSIS AND

RECOMMENDATIONS
APPROACHES TO FINANCIAL
PLANNING

• The life cycle approach

• The pie chart approach
• The financial statement and ratio analysis
approach
• The two-step/three-panel approach
• The present value of all goals approach
• The metrics approach
• The cash flow approach
• The strategic approach

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LIFE CYCLE APPROACH

• This approach gathers and analyzes the following

information:
• The ages of the client and spouse
• The client’s marital status
• The number and ages of children and grandchildren of the
client
• The family income by each income contributor
• The family net worth
• Whether the client is self-employed, an employee,
unemployed or
retired
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APPROACHES TO FINANCIAL
PLANNING

THE PIE CHART APPROACH

• A pie chart forces the client to focus on the fact that
there is only
• one pie.
• People can only spend what they have and visualizing
where the
• money goes is often a sobering lesson.
• The pie chart is an eff ective analytical and illustrative
tool for
• financial planning clients
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PIE CHART APPROACH

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THE FINANCIAL STATEMENT AND
RATIO ANALYSIS APPROACH

The approach uses four types of financial ratios:

1. Liquidity ratios
2. Debt ratios
3. Ratios for financial security
4. Performance ratios

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LIQUIDITY RATIO

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DEBT RATIO

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DEBT RATIO

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 •Client Profile: Mr. X
• Annual income: $250,000.
• Marginal tax bracket: 40%.
• 28/36 ratios of 35/45% (housing and debt
ratios).
•Income Breakdown:
• 100% Salary: Full income before taxes and
expenses.
• (40%) Taxes: 40% of income goes to taxes,
DEBT RATIO: leaving 60% of income.
SCENARIO • (45%) Housing/Debt Ratio: 45% of income after
taxes is allocated to housing and debt-related
expenses.
• 15% Remaining: Only 15% of income is left for
other essential expenses like food, utilities,
clothing, education, and retirement savings.
•Conclusion:
•The client is left with only 15% of their income
after taxes and housing expenses, leaving them
vulnerable to financial instability.
•One catastrophic event could push the client
toward bankruptcy due to the limited available
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FINANCIAL SECURITY RATIOS

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FINANCIAL SECURITY RATIOS

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 The Benchmark:
Formula: Invested Assets ÷ Gross Pay.
Measures progress toward retirement based on an
individual's current age.
PROGRESS Age-Based Targets:
TOWARDS Age 25: 0.20:1 (20% of gross pay invested).

RETIREMENT Age 30: 0.6 – 0.8:1 (60-80% of gross pay invested).

Age 35: 1.6 – 1.8:1 (1.6 to 1.8 times gross pay
invested).
Age 45: 3 – 4:1 (3 to 4 times gross pay invested).
Age 55: 8 – 10:1 (8 to 10 times gross pay invested).
Age 65: 16 – 20:1 (16 to 20 times gross pay invested).

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PERFORMANCE
RATIOS

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TWO STEP APPROACH

The Two-Step Approach in personal financial planning

involves a simple but eff ective strategy to achieve
financial security and independence. Here's a
breakdown of this approach:
Cover the Risks
The first step is to protect against potential risks that could
lead to significant financial loss or dependency on others.
Save and Invest
The second step is to build wealth through disciplined
saving and investing.

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TWO STEP APPROACH

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METRICS APPROACH

The metrics approach provides quantitative example

benchmarks
for the financial planner and client to use as guidance
for achieving
comprehensive financial goals and objectives
• These benchmarks serve as a guide for clients to
understand what needs to be achieved to meet their
comprehensive financial goals.
• It’s a way to measure progress and ensure that the
financial plan is on track.

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.

RISK TOLERANCE AND ASSET ALLOCATION

• Financial planners use tools to assess how much risk

a client is comfortable with when investing.
• PASS Score and Asset Allocation
• Understanding a client's risk tolerance is crucial for
creating a personalized investment plan.

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.

RISK TOLERANCE AND ASSET ALLOCATION

• Determine the Present Value (PV) of Goals

• Sum the Present Values
• Subtract Current Resources
• Treat the Net PV as an Obligation

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.
• No Cash Flow Impact:

• Change Name of Benefi ciary: Adjusting the designated benefi ciary on an

insurance policy has no direct eff ect on cash fl ow but ensures that the policy
refl ects current wishes.

• Assign Policy Ownership to Another: Transferring ownership of a policy does

not impact cash fl ow but can be crucial for estate planning or legal purposes.

• Stop Driving Uninsured Vehicle: Advising to stop driving an uninsured vehicle

minimizes risk without aff ecting current cash fl ow.

INSURANCE Positive Annual Cash Flow Impact:

• Raise Deductibles (e.g., Auto): Increasing deductibles can reduce

RECOMMENDATION premium costs, improving annual cash flow.

S AND ITS IMPACT • Eliminate Duplicate Coverage (e.g., Disability): Removing redundant
insurance policies reduces expenses, positively impacting cash flow.

• Reduce Coverage (e.g., Home Value Declined): Adjusting coverage to

reflect a decrease in asset value can lower premiums and improve cash
flow.

• Replace One Policy for Another (e.g., Term Life): Substituting an existing
policy with a more cost-eff ective one can result in lower premiums,
enhancing cash flow .

Negative Annual Cash Flow Impact:

• Purchase Life, Health, Disability, Long-Term Care, Property, or Liability

Insurance: Acquiring new or additional insurance policies can protect
against risk but may reduce cash flow due to increased premiums.

• Increasing the Amount of Current Coverage: Expanding coverage to

ensure adequate protection can increase premium costs, leading to a
negative cash flow impact.

• Lowering Deductibles: Reducing deductibles may increase premiums,

which could negatively aff ect cash flow.
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DEBT MANAGEMENT
1.C ommon Debt Issues:
Many people struggle with having too much debt, debt with high interest rates, or debt
that isn't well managed. Poor debt management can lead to financial stress and instability.
2.G ood Debt:
Low Interest Rate: Good debt typically has an interest rate that is relatively low when
compared to expected inflation and the returns you might get from investments.
Shorter Payback Period: The debt should be paid off well before the asset (like a house
or car) reaches the end of its useful life.
3.R easonable Debt:
Longer Payback Period: Reasonable debt might have a longer payback period.
4.B ad Debt:
High Interest Rates: Bad debt usually comes with high interest rates, which can make it
diffi cult to pay off and very expensive over time.
Exceeds Economic Life: Another sign of bad debt is when the debt payback period is
longer than the time the asset will be useful.

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THE STRATEGIC APPROACH

•Mission Statement:
•The fundamental purpose of a plan or organization.
•Describes the "why" behind everything you do and sets the tone
for decision-making.
•Goals:
•Broad, long-term targets that align with the mission statement.
•These are the milestones that guide the organization or individual
toward fulfilling the mission.
•Objectives:
•Specific, measurable actions designed to achieve the goals.
•They are more concrete and time-bound, helping to track progress
and success.

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CHAPTER 4:FINANCIAL STATEMENTS
.

FINANCIAL STATEMENTS FOR ANALYZING

FINANCIAL
•
POSITION
Balance Sheet:
•Snapshot of financial health at a specific point in time.
•Lists assets, liabilities, and net worth (Assets - Liabilities = Net
Worth).
•Income and Expense Statement:
•Tracks income and expenses over a certain period.
•Helps identify spending patterns, savings, and whether you’re living
within your means.
•Statement of Cash Flows:
•Shows how cash moves in and out (inflows and outflows).
•Helps assess liquidity and cash availability for expenses and
investments.
•Statement of Changes in Net Worth:
•Measures changes in net worth over time.
•Shows how income, expenses, asset growth, and liabilities affect
overall
financial health
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BALANCE SHEET
•Assets:
•All items of value that are owned (e.g., cash, investments, real
estate, personal property).
•Liabilities:
•All debts or financial obligations (e.g., loans, mortgages, credit card
debt).
•Net Worth:
•The difference between assets and liabilities.
•Formula: Net Worth = Assets - Liabilities.
•Balances at a “Moment in Time”:
•The balance sheet represents a snapshot of financial health at a
specific date, showing exactly what you own and owe at that
moment.

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CLASSIFICATION OF ASSETS
•Cash & Cash Equivalents:
•Highly liquid assets that can be easily converted to cash.
•Examples: Checking/savings accounts, money market funds, and
cash on hand.
•Investment Assets:
•Assets that are held with the goal of generating returns or growing
in value.
•Examples: Stocks, bonds, retirement accounts (401(k), IRAs), mutual
funds, real estate investments.
•Personal Use Assets:
•Assets owned for personal enjoyment or use, rather than investment
purposes.
•Examples: Primary residence, cars, furniture, electronics, and
personal belongings.

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CLASSIFICATION OF LIABILITIES
•Current Liabilities:
•Debts or financial obligations that are due within one year.
•Examples: Credit card debt, short-term loans, utility bills, and
unpaid taxes.
•Long-Term Liabilities:
•Debts or obligations that are due in more than one year.
•Examples: Mortgages, car loans, student loans, and long-term
business loans.

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.

BALANCE
SHEET
•Impact on Net Worth:
•Example: A client purchases $5,000 worth of furniture with cash.
•No impact on net worth: The value of personal use assets (PUA) increases while cash
decreases by the same amount.
•Important Formula:
•Assets - Liabilities = Net Worth: This formula remains unchanged because both assets and
liabilities remain balanced.
Balance Sheet Limitations:
•The balance sheet is a snapshot in time and doesn’t track changes or the flow of money over
time.

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.

STATEMENT OF INCOME AND

EXPENSES:
Income: Lists all sources of income, such as salary, interest, dividends, and
business income.
Savings: Tracks deposits made into retirement accounts, education savings
plans, and other savings accounts.
Expenses: Includes both variable expenses (that fluctuate, like groceries) and
fixed expenses (that stay consistent, like rent/mortgage).
Time Period: The statement shows financial activity over a specific time
period, for example, “For the year ending 12/31/20X1.”
Statement of Income and Expenses Limitations:
•The statement doesn’t capture all financial aspects, such as asset
appreciation or depreciation.

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CHANGES IN NET WORTH & STATEMENT

OF CASH FLOWS
Changes in Net Worth:
• Reflects the increase or decrease in net worth over a specific period.
• Key factors: savings, investment gains/losses, and debt repayment.
• Helps track overall financial progress.
Statement of Cash Flows:
• Shows the movement of cash in and out of the client’s finances over a period
of time.
Divided into three categories:
Cash Inflows: Salary, dividends, interest, business income.
Cash Outflows: Fixed and variable expenses, loan repayments,
purchases.
Net Cash Flow: The difference between inflows and outflows, indicating
whether the client is generating or depleting cash.

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.

IMPORTANCE OF BUDGETING
There are three important tips to being successful in preparing and
using a budget:
• Be realistic with spending behavior
• Budget a line-item expense for miscellaneous expenses and
• unforeseen expenses
• Being successful with a budget takes practice

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BUDGET
• EstablishPROCESS
Goals with the Client:
• Work closely with the client to set clear, realistic financial goals
• (e.g., saving for retirement, buying a home, paying off debt).
• Determine the Client’s Income:
• Identify all sources of income for the given time period
• (e.g., salary, rental income, investment returns).
• Determine Expenses:
• Break down expenses into two categories:
• Fixed Expenses: Regular payments like rent/mortgage, insurance, loan
payments.
• Variable Expenses: Costs that fluctuate, such as groceries, entertainment,
and travel.
• Determine Net Discretionary Cash Flow:
• Calculate whether the client’s income exceeds expenses (positive cash flow)
• or if expenses surpass income (negative cash flow).
• Present Expenses as a Percentage of Income:
• Show how much of the client's income is allocated to each category of
expenses.
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FINANCIAL STATEMENT ANALYSIS

• Financial statement analysis provides insight into a
client’s financial
strengths and weaknesses.
• Allows planners to answer questions related to:
• How well does the client manage debt?
• How well is the client progressing toward financial goals?
• What is the client’s ability to meet short-term
obligations?
• Limitation to financial statement analysis:
• Only provides planners with a historical perspective,
it is not
• predictive of the future

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FINANCIAL STATEMENT ANALYSIS

[Link] Analysis:
1. Compares items on a financial statement to a base number.
2. Helps assess the proportion of each item relative to the total (e.g., percentage of income
spent on housing).
[Link] Analysis:
1. Compares financial data over time.
2. Helps identify trends, growth rates, or changes from period to period.
[Link] Analysis:
1. Uses financial ratios to evaluate specific aspects of a client’s financial health.
2. Examples include debt-to-income ratio, liquidity ratio, and savings rate.

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Liquidity Ratios:
• Measure a client’s ability to meet short-term financial obligations.
• Key examples:
• Current Ratio: Current assets divided by current liabilities.
• Emergency Fund Ratio: Liquid assets divided by monthly expenses.
Debt Ratios and Debt Analysis:
•Evaluate how well a client manages debt and their debt load relative to income or as
CATEGORIES
•Key examples:
OF RATIO •Debt-to-Income Ratio: Total debt divided by gross income.
•Debt-to-Total Assets Ratio: Total debt divided by total assets.
•Performance Ratios:
•Assess how effectively a client is saving or investing, and their financial progress.
•Key examples:
•Savings Rate: Percentage of income saved.
•Investment Assets-to-Net Worth Ratio: Proportion of net worth held in inves

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CHANGES IN NET WORTH & STATEMENT

OF Inflation:
CASH FLOWS
• Makes it challenging to compare financial statements across different time
periods.
• Inflation can distort the true value of assets, liabilities, and income over time.
Use of Estimates:
• Personal use assets are often based on estimates (e.g., home or car values),
which can affect the accuracy of net worth calculations.
• These estimates can be subjective and may not reflect the actual market
value.
Benchmarks:
• There are limited established benchmarks for personal financial ratios.
• Personal financial situations vary, making it diffi cult to apply standardized
benchmarks.
Sensitivity and Monte Carlo Analysis:
• Important to conduct sensitivity analysis to understand how changes in
variables (like inflation or investment returns) affect financial outcomes.
• Monte
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| James Dalton can simulate multiple financial scenarios to assess
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potential risks and outcomes, adding depth to the analysis.
THANK YOU

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