Current and Future Financial Situation
Once you understand what a client wants to achieve, the next step is figuring out where they stand financially. A client's current resources and future obligations determine what is realistic and what investments are appropriate.
Cash Flow Analysis
Cash flow measures the difference between what a client earns and what they spend over a given period.
- Positive cash flow (income > expenses): The client has money available for additional investment
- Negative cash flow (expenses > income): The client may need to liquidate assets to cover shortfalls
Cash flow analysis reveals whether a client can contribute to their portfolio, needs income from it, or is actively drawing it down.
Key components:
- Salary, wages, and business income
- Rental income, royalties, and other passive sources
- Fixed expenses (mortgage, insurance, loan payments)
- Variable expenses (utilities, food, discretionary spending)
Balance Sheet (Net Worth Statement)
A balance sheet provides a snapshot of a client's financial position at a specific point in time.
Assets - Liabilities = Net Worth
| Category | Examples |
|---|---|
| Liquid assets | Cash, savings, money market funds |
| Investment assets | Stocks, bonds, mutual funds, retirement accounts |
| Personal assets | Home, vehicles, personal property |
| Liabilities | Mortgage, student loans, credit card debt, auto loans |
- A high net worth relative to income suggests the client may have greater capacity for risk
- Heavy liabilities reduce the client's ability to absorb investment losses
- Net worth provides context that income alone cannot; a client may have high income but also high debt
Exam Tip: Gotchas
- Cash flow vs. net worth are different views. Cash flow tells you about the flow of money over time; net worth tells you about a client's financial position at a point in time. The exam tests whether you know the distinction.
- High income does not mean high investment capacity. A high-income client with high debt may have limited ability to invest. Always look at the full picture, not just income.
Existing Investments
Understanding what a client already owns is important before making new recommendations.
- Current portfolio composition: What asset classes does the client hold?
- Asset allocation: Is it appropriate for their goals and risk tolerance?
- Concentration risks: Is too much of the portfolio in a single stock, sector, or asset class?
- Unrealized gains and losses: Selling positions with large unrealized gains triggers capital gains taxes; unrealized losses may present tax-loss harvesting opportunities
Exam Tip: Gotchas
- Watch for employer stock concentration. If a client's portfolio is heavily weighted in employer stock, the suitable recommendation is diversification, not adding more of the same.
Tax Situation
A client's tax profile affects which investments and strategies are appropriate.
- Marginal tax bracket: Higher-bracket clients benefit more from tax-exempt municipal bonds and tax-deferred accounts
- Capital gains exposure: Long-term capital gains (held > 1 year) are taxed at lower rates than short-term gains
- Tax-advantaged account usage: Maximizing contributions to IRAs, 401(k)s, and other qualified plans before investing in taxable accounts
- Tax-loss harvesting opportunities: Selling losing positions to offset gains elsewhere in the portfolio
Social Security and Pensions
Expected future income streams from Social Security and employer pensions affect how much additional income needs to come from the investment portfolio.
- A client with a generous pension may need less current income from investments and can afford to pursue growth
- A client with minimal Social Security benefits may need a larger income-producing portfolio
- The timing of when these benefits begin (e.g., claiming Social Security at 62 vs. 67 vs. 70) affects the investment strategy for the interim years
Future Financial Obligations
Advisers must account for upcoming expenses that will draw on the client's resources.
- College funding: Tuition costs for children or grandchildren
- Mortgage payoff: Planned early payoff or refinancing
- Expected inheritance: May allow for a higher-risk approach if the client expects a significant inheritance
- Long-term care needs: Potential costs for assisted living or nursing care, which can be substantial
Future obligations influence both the time horizon and the amount of risk that is appropriate. A client with large upcoming expenses needs more liquid, lower-risk investments for those specific goals.