Many things in life are measured by benchmarks. Personal finance is one of them. Use these ratios to measure your financial success.
If you work with a financial planner, one of the first things a good one will do is put together some information on your finances. It’s the same thing you’d do if you were looking to buy a business or check in on the health of your own business, so why wouldn’t you do it for your personal finances?
You’ll need all of your financial data and monthly transaction data. I use Mint for this because it’s easy, but what’s important is that you have the data to examine. Let’s see where you are.
These ratios should give you insight into your ability to cover your short-term needs. It makes sense to bump up your safety threshold for both if you’re worried about your income stream or if it’s unstable.
If you work for a regular paycheck, you’re likely okay at the lower end of the spectrum. But if you’re starting your own business, working on commission, or are worried about job security, it makes sense to be a little more financially conservative.
Emergency Fund Ratio
Let’s define some terms. Cash and cash equivalents means the sum of your cash (savings, checking account) and anything that can be converted in to cash in less than three months (short term bonds, CD’s, money market fund).
Monthly non-discretionary cash flows is a fancy way of saying everything you need to pay for in a month that you can’t do without. A basic list includes your mortgage or rent, loan payments, credit card payments, insurance payments, taxes, basic food budget, and utilities.
There are more for certain, but one important thing to remember is that it covers the bills you need to consistently pay month to month. This formula is where you get the generic advice that you need to have 3-6 months’ expenses in cash.
Also, if you’re looking for a target number because you’re below where you want to be, all you need to do is multiply your denominator by the number of months you need coverage. This ratio will give you a sense of how long you could go without working before dipping into investments.
Cash and cash equivalents are the same as before and current liabilities mean everything you need to pay within a year. In this case, you’d count 12 months’ mortgage payments instead of the entire amount. This is another way to measure how well you can cover your debts and other necessary payments but extended to a year.
In this formula, you can also include expected income as you’re probably paying bills out of net income instead of savings. In general, having a ratio of 1 means you’re in a good territory and below 1 means you may need to make some changes.
These ratios can give you an idea of how well you manage debt and if there are areas that you need to watch more carefully.
Housing costs refer to either your annual rent or 12 months of your mortgage PITI (principle, interest, taxes, insurance). Your gross pay is your pre-tax income. This is the ratio that lenders use to help determine if you’re going to get a loan and at what rate.
Generally, housing is your biggest expense so it makes sense that you’d want some way to know if you’re at an acceptable amount. This is also highly location dependent. I spent $600/month to share a room in Berkeley and $800/month for a 2 bedroom place to myself in Madison.
If you’re in one of those high costs areas you may need to bite the bullet on this one. The 28% is a maximum, not a target. The lower you can be below it, the better for your finances.
Consumer Debt Ratio
Consumer debts means all of your debt payments except for housing. This includes credit cards, student loans, auto loans, bribe payments, etc. For this one, you again want to add everything up for a year’s worth of costs.
You don’t need to count the entire balance of a student loan, for instance. This ratio is one that will certainly be worse when you’re younger as you’re more likely to have student loans and less likely to be earning a lot. As with the housing ratio, this is a max and not a target.
Total Debt Ratio
Here you’re adding the previous two ratios together and getting a whole debt picture. It may be that you’re living in middle of nowhere Montana but have a ton of student loans. In that case, your housing ratio might look great but when added to your consumer debt ratio, the whole picture is a little darker. Think of this and the previous two ratios as golf, the winner has the lowest score!
Total Assets To Total Debt And Net Worth To Total Assets
Your assets are everything you own with a positive cash value. This includes your cash, investments, equity in your home, vehicles, real estate, and others. Your total debts are the current value of any loans you have.
In general, you want your assets to be larger than your debts. if this is an unfriendly ratio for you, you need to find ways to attack both parts of the equation so you can build assets while paying off debts.
Your net worth is your assets minus your debts. In this case, you want to compare your net worth to your total assets because this can give you a sense of how many of your assets are financed by debt.
A 20% ratio is good if you’re under the age of 30 because you likely have student loans and not many assets. As you start to approach retirement, you really want the number to be 100% as you’re unlikely going to be doing much to increase your assets afterwards.
Because net worth equals assets minus debt this ratio can never be higher than 100% as your assets and net worth would increase in line without any debts.
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Savings And Investments
This simply shows how much of your pay you’re saving. If you have a 401K with employer match, don’t forget to figure that in as well. Generally, you want to be saving as much as you can. A rule of thumb puts anything above 20% as a solid rate. This is football and not golf, you want that high score here.
Investment Assets To Gross Pay
This asks how many times over you could replace your current pay with your assets. The below chart gives a decent idea of benchmarks to use. This is roughly what you can use for a target number for retirement if you assume that you want to replace your current income by drawing down your retirement savings over 20 years. That formula is a bit dated as it assumes you won’t live past 85 and assumes relatively static investment returns over that time.
You will get a strong impression of your financial picture if you put together these ratios for yourself. While they mean something in isolation, they’re even more important as a tool to compare yourself over time.
You should be able to track your personal progress or identify areas where you might need to intervene. It’s also important to take into account your age. Are you under 30? All of your ratios will probably look worse because you have more debt and fewer assets.
Your earnings are almost all ahead of you; use these tools to track your progress. Over 50? You should be outperforming the standard benchmarks. If you’re not, these numbers will give you an idea of where you should start digging more deeply into your finances.
I’ve shown you these tools but it’s up to you to use them. I challenge you to not only fill them out for yourself but let us know how you stack up. It will be enlightening.
Featured Image Photo Credit: “Park bench painted” from pdpics.com