Personal Finance: Financial Ratios and what insight do they give us?

In our “Personal Finance 101” blog, we covered the basics of understanding your assets and liabilities and how the difference will give you your net worth. We also discussed Statement of Cash Flows which outlays your cash flow to provide you with a view of income vs. spending.

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But how do you know if you are spending too much on credit card debt or your mortgage payment? How do your ratios look? In this blog, we will take you through the next step of the financial analysis process, which will ensure that you have the information needed to focus on your goals.

What are ratios?

Ratios are broken down into three categories: Liquidity, Debt, and Savings ratios. Your savings ratio is determined by figuring out your personal savings to disposable personal income. Your liquidity ratio helps determine your ability to meet current debts. Debt ratios help you to know if your mortgage payment is too much or if you have too much credit card debt.

Understanding these ratios will give you a much better insight into decisions such a rent vs. buy a home, savings for education, building an emergency fund, or just about any other financial goal. Let’s take a closer look at each ratio and what it means for you.

Liquidity Ratios

1. Current Ratio: explains the amount of liquid cash available to meet current debt, such as credit card payments. It includes the “cash & cash equivalents” total and current debt from the balance sheet. The ratio is determined by dividing your current assets by your current liabilities.

For example, Susan currently has $1500 in credit card debt. She wants to know if this is too much. Susan knows that she has $150,000 in cash and cash equivalents. Using the formula, Susan now knows that her current ratio is 100.

Now that Susan knows that her ratio is 100, she is confident that her debt is not too much for her financial situation. A good ratio should be a number that can cover your current debt for 6-months. Therefore, if Susan has $1,500 credit card debt every month, she will need $9,000 minimum in cash and cash equivalents to cover her debt obligation.

2. Emergency fund: Typically, everyone should have 3-6 months of savings as an emergency fund in case of any unforeseen circumstances. The emergency fund is calculated by dividing your current assets by your monthly non-discretionary expenses. What are non-discretionary expenses? These are unavoidable expenses such as mortgage or rent, utilities, auto loan, food, insurance premiums, and property taxes.

Susan is concerned about having enough money in her emergency fund. She decides to figure out her ratio by diving her current assets by her non-discretionary expenses. Let’s assume her non-discretionary expenses are $5,000 a month.

Her emergency fund ratio is 30. This lets Susan know that based on her current, non-discretionary expenses, she has enough assets to cover 30 months of expenses if needed. After looking at this ratio, Susan is confident that she has enough emergency savings in place.

Debt Ratios

Debt ratios are broken down into consumer debt, housing debt, and total debt. While housing debt and total debt are calculated using individual gross income, consumer debt is calculated using net income, income after payroll taxes. So how do you know what the ratios are and what are the maximum limits? Let’s assume that Susan’s monthly gross income is $5,000 and her net income is $3,000. Let’s calculate the debt ratios for her:

1. Consumer debt:

Since Susan’s current ratio is 50%, she needs to be careful. When it comes to consumer debt, it is good practice to keep the ratio at 20% or less.

2. Housing Debt:

Susan’s current housing ratio is 24%. She is at the upper limits of the ideal ratio for housing. It is a good idea to keep your housing ratio under 28%. This helps prevent you from biting off more house than you can reasonably afford and still meet your other financial obligations.

3. Total Debt:

Now that Susan knows that her mortgage payments are $1200 a month and her consumer debt is $1500 a month, how do the two numbers together look? This is a crucial ratio for Susan to pay attention to if she wants to keep herself in good financial shape.

Her current total debt ratio is 54%, which is high. It is a good idea to keep this ratio below 36%. Since her ratio is considerably over the recommended limit, Susan might find herself struggling to meet her obligations.

Savings Ratios

What should be the savings ratios and are retirement contributions included in the savings ratio? Susan needs to be aware of her savings as well and making sure she has enough saved for retirement. A conservative number for the savings ratio should be 10-12% of your gross income. This also includes any contributions made to retirement accounts or profit-sharing accounts. Since Susan’s gross monthly income is $5000, she should be saving at least $500 a month in savings and retirement.

At Luminous Financial & Tax Advisors, we know that there are many crucial factors to consider when crafting a financial plan. It can be daunting to look at all of your numbers and figure out where you need to make tweaks or changes. However, it is never a good idea to ignore these numbers!

Give us a call today and let us sit down together and make sure that you are on the right track financially.