First two financial ratios

In my last post, I wrote about the two basic financial reports, net worth and cash flow. These are the building blocks for understanding your current (and potentially future) financial status.

 

The next things to consider are important ratios, where you compare key parts of the main two reports to determine specific financial status. Like Net Worth, ratios are static “snapshots” of current financial status. The important thing with ratios is to track them over time, and see if you are improving your financial situation.

 

Liquidity

 

Liquidity is a measure of the speed at which an asset can be converted into cash without loss of value. Cash, savings, checking and money markets can be quickly turned into cash. Stocks and Bonds (and real assets like gold, real estate, etc.) are more difficult to turn into cash at short notice.

 

Most people require a little bit of liquidity in order to survive (purchase food, pay bills, etc.). The key is to keep your liquidity in line with your other financial goals, and to keep your liquid assets as low as possible (while still being able to sleep at night).

 

The basic liquidity ratio is:

Liquidity Ratio = liquid monetary assets (from balance sheet) / average monthly expenses (from cash flow statement)

 

Liquid assets: Cash, checking, money market accounts, and savings

Two months recommended

 

From our previous post, the individual has a liquidity ratio of $22,200 (from Net worth) / $6,414.58 (annual expenses divided by 12) = 3.46 months for liquidity.

 

If your income is steady and your job secure, with predictable expenses, you probably don’t need much more than 2x your expenses in liquid assets. Many financial advisors (like Dave Ramsey) recommend building up this “emergency fund” to as much as 6 months. Some folks (like Mrs. 39 months) like it as high as 12+ months.

 

Debt Ratios

 

The purpose of debt ratios is to determine the amount of financial leverage you currently use, and to track as you (hopefully) improve. The objective is obviously to become debt-free, especially if you want to be financially independent. The debt-to-asset ratio is very useful for tracking progress.

 

The data source is entirely the balance sheet. Debt-to-asset ratio = total debt / total assets.

From our example last post, $96,500 Debt / 335,300 Assets = 0.288

 

Another Debt ratio that is good to track is the Debt-to-Gross income ratio, which is the total debt payments / annual take home pay (pay after taxes, medical, etc.). It is used to help determine your ability to pay the debts off.

 

The source of the data is the cash flow statement.

From our example last post, $$11,400 (mortgage & debt payments) / $45,925 (total take home pay) = 0.248 or 24.8%. This is pretty good, as you should never take on debt payments (including student loans) of over 36% of salary.  Another recommendation is not to take on housing costs (mortgage or rent) of more than 28% of salary.

 

For my next post, I’ll talk about Savings Ratios and Real Growth rate ratios.

 

Mr. 39 Months

Basic Financial Documents

Basic Financial Documents

 

I was going to start some postings on basic finance documents and ratios, for a FIRE reader to use to start tracking their performance and see how they are doing over time. The key with all of these is that they are “snapshots” in time, which give you a single image. You have to rack them, over time, to see how you are doing.

 

Comparing yourself to others is madness (and is the heart of the “keeping up with the Joneses” spending which has caused so many issues in the current culture.

 

Instead, track yourself, and see yourself improving. By doing that, you can see your improvement over time. That should provide motivation enough to keep moving forward.

 

Net Worth

  1. Assets: Items you own. Don’t get too complicated here, because you will have to maintain it regularly. Keep it as simple as possible
    1. Liquid assets (cash, checking, savings, money market)
    2. Investments (stocks, bonds, real estate, etc.)
    3. Personal assets (home, cars, property, etc.) – be very realistic here. They aren’t very liquid, so difficult to generate cash from them
  2. Liabilities: Debts or amounts that you owe
    1. Short-term: pay off in next 12 months (credit card, utility bills, etc.)
    2. Long-term: payoff that requires more than 12 months (auto loans, mortgages, student loans, etc.)
  3. Net worth:

Net Worth = Assets – Liabilities

 

Here is a sample Net worth Statement (not mine)

Assets Total
Financial Assets
Cash $200
Checking $3,000
Money Market Accounts $7,000
Savings $6,000
Certificates of Deposit $6,000
Total financial Assets $22,200
Personal Assets
Clothing $12,000
Furnishings $15,000
Auto $20,000
Home $150,000
Other $1,100
Total personal assets $198,100
Investments
Stocks $0
Bonds $0
Mutual Funds $25,000
Retirement Plans (401K, IRA) $90,000
Life Insurance Cash Values $0
Real Estate $0
total Investments $115,000
 
TOTAL ASSETS $335,300
Liabilities
Short Term
Utilities ($500)
Credit Card ($2,000)
Other $0
total short-term debt ($2,500)
Long Term
Auto Loans ($3,000)
Student Loans ($15,000)
Home Mortgage ($76,000)
Other $0
Total Long-term debt ($94,000)
TOTAL LIABILITIES ($96,500)
NET WORTH
Total Assets $335,300
Total Liabilities ($96,500)
Net Worth $238,800

 

The Net Worth is a snapshot in a period of time (I take mine on Jan 1 of each year). You should track it at regular intervals. Your Goal is to increase your net worth to achieve a desired degree of financial security, and to eventually be able Financially Independent.

 

 

Cash Flow Statement

 

The Balance Sheet lists values for a single point in time. Your Cash Flow statement will show activity over a period of time, like a year. It has two sections – sources of income and expenses. Sources include any activity that produces cash for you to spend. Expenses list your expenditures (mortgage/rent, food, auto loan, insurance, etc.)

 

It’s helpful to divide the expenses into two categories – fixed and variable. Fixed are often non-negotiable (mortgage, insurance, etc.) while variable expenses are often under your control (dining out, vacations, etc.). Note that developing the cash flow statement can be difficult for many, as tracking your expenses at first seems to be a monumental task. Start with a shorter time frame (a month, or a week) and build from there.

 

Cash Flow

  1. Income: Includes all sources of cash
    1. Wages
    2. Pensions
    3. Investment income
    4. Cash gifts received
    5. Loans
  2. Expenses
    1. Payroll deductions (taxes, health insurance, Social Security, 401K, etc.)
    2. Fixed Expenses (mortgage payments, loan payments, utility bills, property taxes, etc.)
    3. Variable Expenses (Food, dining out, clothing, gifts, etc.)
  3. Cash Flow

Cash Flow = Income – Expenses

 

 

Here is a sample Cash Flow Statement (not mine)

CASH FLOW STATEMENT
Sources of Cash
Wage/Salary $77,000
Interest $900
Investment Distributions $1,200
Total Sources $79,100
Payroll Deductions
Federal Income Tax ($14,000)
Social Security Tax ($5,775)
State Income tax ($3,500)
Medical Insurance Premium ($2,400)
401K plans ($7,500)
Total Payroll Deductions ($33,175)
Fixed Expenses
Mortgage ($7,800)
Loan Payments ($3,600)
Utilities ($5,000)
Insurance ($3,000)
Property Taxes ($3,000)
Investment plans ($6,000)
Total Fixed Expenses ($28,400)
Variable Expenses
Charitable contributions ($2,400)
Clothing ($3,000)
Education $0
Food ($5,000)
Gifts ($2,000)
Travel/Vacation ($3,000)
Total Variable Expenses ($15,400)
CASH FLOW
Total Sources of Cash $79,100
Total Expenses ($76,975)
Cash Flow $2,125

 

Again, keep your cash flow records as simple as possible. Excessively detailed records require more maintenance, increasing the chance that you will get tired of updating the information. It is better to have a simple statement that you update regularly than a complicated tracking system.

 

Your first cash flow statement is often the most difficult to develop. As you do more, you will find it easier because you have a starting point to go off of.

 

Understanding your cash income and your expenses is a critical step to taking control of your finances. From here, you can make plans, determine tradeoffs, and make educated guesses on where to add and where to cut back. This will enable you to focus your expenditures toward your financial priorities.