Anyone concerned about his economic situation knows that he can’t make any decision by chance. Before deciding, it’s essential to analyze several factors — and you can’t leave out personal finance ratios.
However, many people do not master the subject and tend to make mistakes. Consequently, they get into trouble and fail to get the results they want. Thus, this post removes your main doubts about the subject and shows 6 ratios regarding personal finance that you need to monitor closely. Come along!
What are Personal Finance Ratios?
Personal Finance Ratios are indicators (coefficient, index, percentages) calculated by reporting two pieces of information from a person’s financial statements (income statement, balance sheet). The main aim of this is to assess your financial health at a given time effectively.
Importance of Personal Finance Ratios
The captain of a ship that sails without direction has a great chance of sinking. Taking the due proportions, this happens to a person who does not analyze his finances through finance ratios.
If you do wrong, you will probably not pay the bills and leave the budget in the red. To avoid these situations, it is essential to monitor everything that happens in management – and this is only possible based on the financial indicators and ratios.
These values widen your field of vision, allowing you to have more accurate attitudes. Over time, planning becomes more effective, and errors tend to decrease.
Top 6 Personal Finance Ratios
To assess how your finances are doing, especially to see how your wealth-building is going, you can use the following ratios::
The concepts of profit and profitability look the same, but they represent different ideas. Profit is related to what you invoice in addition to expenses. On the other hand, profitability shows the percentage of profitability of your business or source of income.
We’ll start with the most basic metric of your personal finance that you probably already know. How much money do you make every month?
If you have a “normal” job and receive a steady paycheck, this is fairly easy to calculate. If you are an entrepreneur, contractor, or consultant, this can be a little tricky.
Your income index determines how much you can spend and save. The higher your income, the easier you can achieve your financial goals.
Income index = Net Income / Net Spending
Furthermore, the rule states that you shouldn’t spend above 28% of your monthly gross income on housing (including principal, interest, taxes, and insurance).
Your total debt payments (housing and all other debt) should not be above 36% of your income. Limit your mortgage payment (including HOA fees, insurance, and taxes) to at most 25% or lower than your monthly take-home pay on a 15-year fixed-rate loan.
As the name suggests, this indicator aims to measure total personal indebtedness. It brings important information, as it shows how much a person is leveraged. (Leverage is when the individual has more obligations than his total equity).
A high indebtedness means interest cost and can be a hindrance to advancing in personal finances. Its calculation is simple: it is the division of the total liabilities (the total liabilities) by the total assets (the assets and money that a person has).
Debt ratio = Liabilities / Assets
Information on assets and liabilities is taken from the Balance Sheet. The lower the Debt Ratio, the better. Ideally, it should be close to zero, and you must take special care so that it does not exceed 100%.
This shows the percentage of monthly income left to invest. From personal indicators, for those seeking financial independence, this is fundamental.
To find the savings index, the formula is:
Savings index = Available result to invest / Income
Information for the calculation is taken from the DRE. To find the result available to invest, calculate the amount of income minus expenses.
There is no suitable number resulting, but we consider 20% a magic number for this index. If you add this by 1% every three months, in four years, you’ll be saving 16% more than you are today.
Before we move on, you must understand that liquidity measures how quickly an asset can be converted to cash without losing value. In other words: how fast can you turn an asset into cash? The faster the speed, the greater the liquidity.
Thus, this index indicates how many times the most liquid assets (which are those that you can quickly transform into cash on hand) outweigh the most immediate expenses (which are the short-term liabilities).
Among all personal indicators, the liquidity ratio deserves special attention. Think about it: You have expenses that you need to pay quickly.
To fulfill the immediate obligations, it will be necessary to have resources available. Otherwise, you will have to resort to overdraft, credit card interest, loans, etc.
As our daily life is based on liquidity, this index shows whether a person is experiencing financial difficulties or not. When the index is less than 1, the individual does not have the money to pay his immediate commitments.
To calculate the Liquidity Ratio, you take the short-term assets (immediate receipts) and divide them by the short-term liabilities (immediate obligations):
Liquidity Ratio = Short Term Assets / Short Term Liabilities
Of the personal indicators we are talking about here, the liquidity index guarantees the quality of life we often mention when we talk about personal finance.
Imagine that you lose your job. How many months will you be able to survive on your short-term assets? Or, if you spend $6,000 per month, how many months will you be able to support yourself if you lose your monthly income capacity?
Of the personal indicators, the Coverage Ratio is what brings this answer. You can calculate it by dividing your short-term assets by monthly expenses:
Coverage Ratio = Short Term Assets / Monthly Expenses
Information on short-term assets is taken from the Balance Sheet. The expenses are in the DRE.
The coverage ratio gives you peace of mind in case something happens and the comfort of making decisions. A value that we can consider ideal for this index is above six months. But that depends on how to subject a person is to losing their job or failing to earn money.
The Wealth index is a Personal Finance Ratio that tells whether a person has become financially independent or not.
The wealth index answers the question: how much does passive income (that which does not come from work) contribute to paying monthly expenses? The goal here is to be able to pay monthly expenses using only equity income.
Imagine a person who spends $7,000 a month and earns $10,000. This same person has assets that generate an income of $ 9,000.
If he stops working, the equity income (passive income) will be enough to pay his monthly expenses. That is, the person in our example has achieved financial independence.
You can obtain the wealth index calculation by dividing passive income by monthly expenses:
Wealth Index = Passive Income / Monthly Expenses (DRE).
When the index is greater than 1, it means that independence has been reached. A recent investigation by the Center for American Progress on Expense Ratios of Investments also discovered that the average 401(k) plan charges a fee of 1% Another study by the ICI discovered that the average mutual fund expense fee is.63% Why are these numbers important?
If the fees and expenses are 1.5 percent, your account balance will grow to only $163,000. The 1 percent difference in the fees and expenses would reduce your funds at retirement by over 28 percent.
Personal Finance Ratios: FAQs
What are personal financial ratios?
Personal financial ratios are indicators that show you the distance you need to travel to have financial independence. However, more than that, they present you with points that you need to improve.
For example, if your debt ratio is high, the first step is to create an action plan to pay off your debts. On the other hand, if the savings rate is very low, a good solution might be to control expenses better.
What is a good personal current ratio?
A current personal ratio is good when it is above 1. This indicates that the individual has enough money to pay his obligations in the short term.
What should a personal liquidity ratio be?
A personal liquidity ratio should be above 1. When the index is below 1, the individual does not have the money to pay his immediate commitments.
What is a good personal debt to the net worth ratio?
A good personal debt to net worth ratio is one whose values range between 0.3 and 0.6. For people with higher values, it would not be easy to access loans.
What is a good financial ratio?
A good financial ratio presents suitable financial information regarding a person or company.
What is a good asset to income ratio?
A good asset to income ratio is below 36%. Specifically, it’s best to invest in a percentage of stocks equal to 100 minus your current age, with a bond allocation to make up the remaining balance. For example, an investor who is 40-years-old should invest in 60% stocks and 40% bonds.
In conclusion, having adequate information about your financial state is quite essential. Personal finance ratios are an important part of maintaining a healthy financial life. Understanding the different personal finance ratios and how they can be applied to your financial situation will help you maintain control over your finances.
Here, we have experts who understand these principles and know how to apply them to create a plan that works for you! We would love to work with you on creating the best possible strategy for achieving success in all areas of money management, so please reach out if this sounds like it might interest you or someone you know. Let us show you what is possible when working with our team! You can adequately handle this via the Personal Finance Ratios highlighted above.
I am Lavinia by name and a financial expert with having a degree in finance from the University of Chicago. In my blog, I help people to educate by making wise choices regarding personal investment, basic banking, credit and debit card, business education, real estate, insurance, expenditures, etc.