Personal Finance Ratios: Measuring Your Financial Position
Financial statements – cash flows and balance sheets, can tell a lot about one’s financial condition. To an even greater extent, personal finance ratios are great metrics to use to evaluate your financial strengths and areas that need improvement. These benchmarks can help you understand and develop better financial habits in saving, spending, and budgeting. Below are a few ratios to keep in mind:
While this is not a ratio in the literal sense, you should still calculate this key metric over different time periods (monthly, quarterly, or annually) in order to track one’s wealth. Ideally, you should see increases in net worth over time.
Formula: Total Assets – Total Liabilities = Net Worth
This is one of the main ratios that you should keep in mind. Unexpected events may arise (Job Loss, Medical Expense, Car Repair, etc.) and you should have a safety net which provides a sufficient cushion. The first step is to understand what your nondiscretionary monthly expenses are (Mortgage/rent, insurance, utilities, groceries, etc.) and then compare that to how much cash has been earmarked for an emergency fund.
While at a minimum it is advisable that one keep a three-month emergency fund, one should aim for a six-month emergency fund.
Formula: Monthly Expenses x 6 = Emergency Fund
This metric acts as an extension of one’s emergency fund. If, for example, the need arises to use an emergency fund, this ratio will examine how many months of expenses will be covered by liquid assets – cash or cash-like equivalents like money market funds or savings bonds. One should hope to maintain a liquidity ratio between 3 – 6 months.
Formula: Liquid Assets/Monthly Expense = Liquidity Ratio
This metric is a great way to track one’s coverage of debts. This basically indicates what percentage of income is being accounted for debt repayment while the leftover percentage is accounting for other household expenses and savings. This lower the ratio, the better debt management one has. It generally advisable that this ratio not go above 36% though we advise our clients to aim for a much lower ratio than this.
Formula: Debt Payments/Gross Income = Debt-to-Income Ratio
The purpose of this ratio is to measure how much one can afford to spend on a home. This is one metric that one usually sees a certain level of overspending. To calculate this metric, one should factor in mortgage/rent, property taxes, insurance, and utilities. It is generally advisable that this ratio not go above 28%. As with the Debt-to-Income Ratio we advise our clients to aim for a much lower number than this.
Formula: Monthly Housing Costs/Gross Monthly Income = Housing Ratio
Retirement Savings Ratio
The savings ratio is designed to show how much money one is saving over a period of time. This factors in savings from all sources – employer-sponsored retirement plans, IRAs & Roth IRAs, and taxable accounts. You should exclude savings earmarked towards an emergency fund, college, new home, or a vacation. Typically, one should have a saving rate of 10% - 20%. As a younger saver you may start at 10%, but as your income rises, you should also increase your savings rate.
A monthly savings ratio can be calculated in the same manner which can help with planning throughout the year if you are trying to hit a specific savings target.
Formula: Savings/Gross Income = Savings Ratio
Bringing It All Together
While there are several other ratios you can use, the ones mentioned above should, at a minimum, be included when analyzing your financial situation. While they do not replace the value of a comprehensive financial plan, being aware of your financial strengths and areas of improvement is important nonetheless.
Weingarten Associates is an independent, fee-only Registered Investment Advisor in Lawrenceville, New Jersey serving Princeton, NJ as well as the Greater Mercer County/Bucks County region. We make a difference in the lives of our clients by providing them with exceptional financial planning, investment management, and tax advice.