Do you want to get a better sense of your financial health now?
Personal financial ratios can give you a picture of your financial health and progress relative to your goals. These benchmarks can help you develop better financial habits in these areas: savings, retirement, spending, investing, and debt management. While businesses use these ratios, we can use them for personal financial planning.
Your personal financial statements, specifically net worth and the monthly budget, use your financial data to describe an individual’s or household’s financial condition. With some number-crunching, you can calculate personal finance ratios as tools designed to evaluate your financial strength and position.
Before providing you with a loan, lenders look carefully at our financial statements and tackle many personal financial ratios.
Net Worth And Budget Are Key Tools
Your net worth and monthly budget statements are essential financial statements to create, review, and update. As such, they hold the key to your current financial life. Net worth is a snapshot of your financial condition. To calculate net worth, use total assets or what you own, less total liabilities or what you owe. Hopefully, what you own is more than what you owe. You may sometimes come across tangible net worth, assets that don’t include intangible amounts like goodwill or royalties.
Your monthly budget is your income statement—total income sources less total expenses (fixed and variable expenses). If your income exceeds your costs, you have money to save. You can use these savings to bulk up your emergency fund, pay down debt, and invest for the future. When your expenses exceed your income, you will need to earn more, borrow to pay costs, reduce spending, or combine these.
Liquid Net Worth As A More Realistic View
Liquid net worth is an even better and more realistic benchmark because it focuses on your assets’ ability to convert quickly into cash with little or no loss of value. Although net worth remains a helpful gauge, it doesn’t differentiate your holdings from their liquidating value.
As such, liquid net worth gives you a better understanding of your assets and your future needs, whether you are running out of cash or even exploring an opportunity. Drilling further down, the current ratio is among the best financial ratios. This ratio is easy to calculate and measures your liquidity position. Financial flexibility allows you to react to and adapt to changing financial conditions like a recession and losing your livelihood.
Financial Advisor Will Help You With Your Plan
Bring your financial statements when you go to a financial advisor. They will review your information and prepare personal finance ratios. Once you calculate these metrics, you can better assess where you stand financially now and over your life cycle.
However, you don’t need a professional. On the contrary, providing these statements and reviewing your financial ratios will go far in developing your financial plan. Your advisor can better help you meet your financial goals.
Related Post: How To Choose A Financial Advisor
18 Personal Finance Ratios:
1. Liquidity Ratio
Liquidity refers to your ability to convert assets quickly into cash with little to no loss of principal. When you are liquid, you can pay for unexpected costs such as a loss of a job, death in the family, or your roof leaking.
Monetary assets are the most liquid assets. These assets include cash, cash-equivalent securities or money markets, savings bonds, savings, and checking accounts. Use your liquid assets to support your fixed monthly expenses for six months.
Liquidity Ratio= Monetary Assets/ Monthly Expenses
Your monetary assets should support your fixed monthly expenses such as groceries, rent or mortgage, utilities, and a car loan for six months. A six ratio means your monetary assets can pay for your basic needs of food, rent, utilities, and a car loan for the next six months, if necessary.
2. Emergency Fund Ratio
The liquidity ratio is linked very near to the emergency funds. You should use this emergency cushion for unforeseen events. Such events may mean job loss, family death, unexpected surgery, or immediate house repair. The emergency fund ratio works by using a targeted number of months you believe is ample to support you through emergencies. If you are looking for six months or higher (and this is highly recommended at a minimum) coverage of monthly expenses to set aside in one fund, invest the money in a high-yield savings account or money markets. Then:
Emergency Funds Ratio= 6*Monthly Expenses
This ratio will give you a targeted amount of monetary assets needed to be comfortable for a possible emergency.
Related Post: Why You Need An Emergency Fund
3. Net Worth Ratio
Your balance statement measures your net wealth at a point in time. As you add to your assets, hopefully outpacing your liabilities, you will get wealthier.
Net Worth Ratio= Total Assets Less Total Liabilities
As discussed earlier, your total assets are what you own at their current market value. Your total liabilities are what you owe based on your debt obligations, notably the balances on your credit card debt, mortgage, car loan, and any other loans you have. The higher the positive number you have, the better off you are.
4. Targeted Net Worth Ratio (The Millionaire Next Door)
One of my favorite personal finance books, The Millionaire Next Door, is an oldie but a goodie. I have read it at least twice and refer to it when teaching my college students about overspending—the book advocates saving and investing money. The high savers do a better job of maintaining and building your wealth. They use age as a factor in the calculation, as some other ratios do.
Targeted Net Worth Ratio= Age x (Pretax Income/10)
Your targeted net worth provides you with an indication of what you should be worth after liabilities. As a 30-year old making $95,000 annually, your net worth should be $285,000. The calculate is 30 x (95000/10). This guidepost can help you reach your goals, particularly financial security.
5. The Current Ratio
Several ratios may seem familiar to you. The current ratio is standard when analyzing the strength of a company’s balance sheet and its ability to meet its short-term obligations. A current personal ratio is essentially the same.
The current ratio is the best benchmark to determine liquidity in your household. It measures the household’s ability to repay a short-term debt in an emergency. The calculation matches short-term monetary (i.e., liquid assets) assets to short-term liabilities.
Current Ratio = Short-term Cash Assets/Short-Term Liabilities
Liabilities are the debt payments owed in the current year. Current liabilities would include your monthly credit card balances and other debt payments owed that year. A ratio of one or higher indicates you have more short-term assets than debt, a sign of good financial health. The quick ratio is similar to the current ratio, but it is more conservation as it uses only highly-liquid assets as part of current assets.
6. Debt-to-Asset Ratio
The Debt-to-Asset ratio is a standard ratio for companies. This ratio focuses on the borrowing ability of the individual or household. Industrial firms are more accustomed to higher debt levels because they are capital-intensive. Individuals should not have high debt levels. Some households have high financial leverage, which is borrowing to buy things like a house that may provide more value in the future.
Total Debt-to-Asset Ratio= Total Liabilities/Total Assets
If you have a high debt-to-asset ratio, you should reduce your debt. It is essential to lower your overall costs for maximum long-term financial flexibility. Particular loans are common to most of us. Total liabilities may include balances on student loans, mortgages, car loans, and credit card debt.
Your liabilities should not go over 50% of your total assets. A great goal is a 10% ratio or as little debt as possible. Avoid high debt, or consider a debt reduction plan.
7. Debt-To-Income Ratio
A better way to look at whether your debt burden is too high is to compare it to your gross income, the amount you make.
Debt-To-Income Ratio = (Annual Debt Repayments/Gross Income) x 100
Typically, when you are in your 20s-30s, your salaries are at the low end of your career. You may be borrowing for a home or a car while still paying student loans. Your debt-to-income ratio should be no more than 36% of gross income and decline as you command higher salaries.
8. Debt-To-Disposable Income
Looking at monthly non-mortgage debt relative to monthly disposable income is worthwhile. Monthly disposable income is net of costs and taxes; and what is available for paying down debt, saving, and spending by the household. Non-mortgage debt excludes your mortgage, which is the most significant part of your liabilities. Lenders look at this ratio carefully before providing you with a mortgage.
Debt-To-Disposable Income = monthly non-mortgage debt payments/ monthly disposable income
The percentage should be 14% or lower. 15% or more is problematic and may reflect a household carrying too much debt.
9. Personal Cost of Debt
Carrying too much debt relative to income is problematic. This ratio looks at your cost of debt influenced by your credit mix and FICO score. If you have high monthly credit card balances, you probably pay a high-interest rate on that debt. Card companies notoriously charge high-interest rates.
Also, your credit score matters. If you have a lower FICO score below 650, lenders will see you as a risky borrower and charge higher interest rates.
Pay Down High-Cost Debt
There are two types of debt reduction plans: the Snowball Method (tackles the smallest debt first) and the Avalanche Method (gets rid of the highest cost first). I prefer the Avalanche Method to get rid of the highest interest cost of debt first. Eliminate your credit card balances by paying your bills in full.
Related Post: How To Pay Down Your Debt For Better Financial Health
Personal Cost of Debt = (Loan 1/Total Debt)x(Interest Rate for Loan 1) + (Loan 2/Total Debt)x(Interest Rate for Loan 2)
Debt Amount Interest Rate % % of Total Debt Interest Rate x Weighting
Loan 1 $25,000 7.0% 42% 2.9%
Loan 2 $35,000 4.5% 58% 2.6%
Total $60,000 100% 5.5%
Your goal would be to reduce your higher-cost debt, loan 1. You would first target reducing the $25,000 loan outstanding. In considering net worth, you want your assets to be larger than your liabilities. Your investments should ideally earn returns above your cost of interest.
For example, stocks generate higher pretax returns of 9% over the long term, or 6%-7% after-tax returns. Therefore, you should carry debt at lower costs than stock returns.
Your household is your business. Businesses look at borrowing capital for projects. They seek projects that can generate returns above their cost of capital. Similarly, you want to earn higher returns in your investments than in your borrowing.
10. Solvency Ratio
Could you pay all of your debt using existing assets if you had to due to unforeseen events? This ratio helps you to determine if you can take care of your obligations.
Solvency Ratio = Net Worth/ Total Assets
Net worth equals total assets less total liabilities. The solvency ratio indicates the individual’s ability to repay all the existing debt with the assets. We add debt to acquire assets that we hope will be worth more than the debt. The higher the ratio, the better your financial condition.
11. Investment Assets-To-Total Assets Ratio
The more you save and invest, the better your road to being wealthy. This metric shows you how well you are doing in accomplishing your financial goals.
Investment Assets-To-Total Assets Ratio= Investment Assets/Total Assets
Throughout your life, you want to accumulate investment assets. These assets include stocks, bonds, money markets, mutual funds, and retirement accounts. Using the power of compound growth, they should expand in their 20s and beyond. Target a ten ratio when you are in your 20s. Your investment assets should expand as you age, pushing your percentage higher.
12. Savings Ratio
Adopt a “Pay Yourself First” attitude. Savings should be one of the most critical parts of your household’s financial goals. Your monthly budget should call for savings at least 10% of gross income. That should be just a start.
Savings Ratio = Savings/Gross Income
Savings refer to money in the bank, liquid funds, deposits, money markets, and other liquid funds, such as your emergency fund. Gross income is your total income source on your budget and includes what you earn, side businesses, bonuses, dividends, and interest income.
Your savings rate should be at least 10% of gross income. Savings may be challenging to do when you first start to work. As your salary or what you make rises, it should get more comfortable to put money away for savings. A healthy savings ratio of 20% would be a bonus (pardon the pun).
13. 50-20-30 Budget Ratio
Harvard Professor, now Senator Elizabeth Warren, is known as a bankruptcy expert. Warren popularized this ratio in her book written with her daughter in 2005, “All Your Worth: The Ultimate Lifetime Money Plan.”
Essentially, you are allocating your after-tax income into three budget buckets:
- 50% of your spending is for your needs, notably housing, utilities, groceries, car payments, and other needed fixed expenses.
- 20% of your budget is saved and can pay down debt, emergency funds, and investing, or combination.
- 30% are for your wants: discretionary or flexible spending for entertainment, vacations, and shopping. After your priorities, the remaining amount is for your desires.
Start Budgeting Early
Budgeting is tricky when you are younger and just starting in your life. You may carry student debt and rent an apartment while your salary is at the beginner’s level. On the other hand, you have fewer costs to monitor, making it an excellent lifelong habit. Use it as a motivational tool to save more and spend less. Be diligent in improving your money management skills.
Related Post: 10 Ways To Better Manage Your Spending
14. Mortgage Ratio
This ratio is a standard metric you will encounter when you get a loan to pay for your home. Borrowing for your home is usually the most considerable total debt. Your home may be an appreciable asset and considered “good debt” versus other kinds of debt, especially credit cards, which are more expensive and harmful.
Buyers usually put down 20% and borrow 80% of the negotiated home price when they buy a home. A fixed 15-year or 30-year mortgage will determine your monthly payments. A shorter mortgage is desirable if you are willing and able to pay higher monthly payments. You will pay lower interest costs over the loan’s life overall than the 30-year mortgage.
Mortgage Ratio = 2.5 x Primary Income= Mortgage Payment
The total home loan is calculated based on $300,000/.80 (or borrowing 80% of the price). If you make $120,000 annually (reasonable if you are dual earners), you should not borrow more than $300,000 for a house priced at $375,000. Some buyers like to put down more money, say 30%, to drop the amount you need to borrow.
Related post: 7 Steps To Buying A Home
15. Total Debt Service Ratio (aka Front End Ratio)
This ratio is what lenders crunch when looking at how capable you are in servicing your housing debt.
Total Debt Service Ratio = Monthly housing costs/ Gross monthly income
The housing costs are primarily your mortgage costs and property costs. Lenders look at a 28% ratio as desirable, with anything over 36% being excessive. This ratio is sometimes called the 28/36 rule.
16. Life Insurance Ratio
The life insurance ratio is simple, but this benchmark should be a starting point for determining life insurance coverage. Life insurance is essential for families, particularly with children. Single people should also consider a policy, but their needs may differ. Insurance sales folks will use this ratio to discuss your circumstances.
Life Insurance Ratio = 10 x Primary income
Consider what your family needs to protect with the life insurance policy. The amount of your policy needs to cover your household’s fixed expenses and your children’s needs, including college costs. If you make $100,000 a year, the ratio indicates that you get a $1,000,000 policy.
A single person buying a $1,000,000 policy may be excessive. However, if your household has three young children with only one spouse working, that amount may not cover your family adequately.
Related Post: A Beginner’s Guide To Insurance
17. Investing Ratio
This ratio guides you to the stock asset allocation in your investment portfolio. Age plays a big factor in this ratio. Generally, the younger you are, the more you can tolerate risk instead of someone approaching retirement.
Investing Ratio = 120 – Age
If you are 25 years old, then 120 less 25, your portfolio could allocate 95% stocks/ 5% bonds. Stocks carry higher risk producing higher returns than bonds. As you age, your risk tolerance goes down with lesser years to accumulate growth in your portfolio. A 50-year-old should be moving their allocation to 70% stocks/30% bonds. For many closing in on retirement, a 50%/50% or less is appropriate.
The ratio is a gauge for asset allocation in your portfolio. Take your circumstances and risk appetite into consideration.
Related Post: 10 Tips To Diversify Your Investment Portfolio
18. Retirement Savings Ratio
There is a Chinese proverb: “Don’t wait until you’re thirsty to dig a well.”
Saving for retirement should begin as early as possible so your nest egg can benefit from compound growth. As soon as you start your first job, you should take advantage of your employer’s sponsored retirement plans, usually a 401K, and contribute to your account. Save enough to earn your employer’s matched contribution. Open a Roth IRA plan.
Retirement Savings Ratio = 25 x Primary Income
If you make $100,000, your retirement savings should amount to $2.5 million. This ratio is also called the 25X Rule.
This ratio complements the 4% Withdrawal Rule developed by William Bengen in his study, “Determining Withdrawal Rates Using Historical Data.” The 4% withdrawal rule means you should be able to live during retirement by withdrawing 4% of $2.5 million in assets, or $100,000. It is not a coincidence that 25 x 4% equals 100%. The math at least works perfectly.
Bengen was a financial planner from MIT. His study said that if you withdraw 4% of your assets annually (recently, Bengen raised the number closer to 4.5%), your retirement savings could last 35 years. Others have said a better withdrawal rate is closer to 3%.
The point of this ratio is to use it as a guideline rather than something etched in stone. You need to figure out what kind of lifestyle you will have in retirement.
Related Post: Saving For Retirement In Your 20s
These financial ratios are useful as a starting point to understanding your financial health. They do not take the place of a sound financial plan. Gathering your financial data to develop a net worth statement and a monthly budget plan is essential. It may help you identify your risks when carrying too much high-cost debt. If so, change your spending and reduce credit card debt. Get in financial shape!
Use the ratios to see where you stand relative to your financial goals and change how you save, spend, borrow, and invest.
Thank you for reading!
Let us know what ratios you find most useful. Do you know of a ratio we missed and should include? Please let us know. We would like to hear from you.
With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.