Cash Flow and Net Worth Management
Cash Flow and Net Worth Management
This domain tests construction and interpretation of personal cash-flow statements and net-worth statements, plus the ratios used to diagnose liquidity, debt capacity, and savings adequacy.
Core rules and concepts
- Cash flow: cash inflows minus cash outflows; separate fixed, variable, and discretionary expenses; include irregular items such as insurance premiums and taxes.
- Net worth: fair-market value of assets minus liabilities; classify assets as liquid, investment, retirement, and personal-use.
- Emergency fund: generally 3–6 months of essential expenses; more for variable income or single earners.
- Housing ratio: monthly PITI divided by gross monthly income; a common target is ≤28%–31%.
- Total debt-to-income: all monthly debt payments divided by gross monthly income; ≤36%–43% is often cited.
- Savings rate: annual savings divided by gross income; 10%–15% is a common planning benchmark.
- Liquidity ratio: liquid assets divided by monthly expenses.
Worked example
Client gross income is $120,000 ($10,000 monthly). PITI is $2,800, other debt payments are $600, liquid assets are $18,000, and essential monthly expenses are $6,000. Housing ratio = $2,800/$10,000 = 28%. Total DTI = $3,400/$10,000 = 34%. Emergency fund = $18,000/$6,000 = 3 months. If the client saves $12,000 annually, savings rate = 10%. The ratios are acceptable, but the emergency fund is at the low end; the adviser should prioritize building it before increasing discretionary spending.
Traps
- Using net rather than gross income for ratios.
- Counting retirement accounts as emergency reserves.
- Ignoring irregular expenses and taxes.
- Double-counting an asset or omitting a liability.