The final ratios I want to discuss are Savings ratios and Growth ratios
You can use current income to pay for current consumption or to pay off past debts . The other option is to purchase assets that grow and create wealth – wealth that will provide financial security. This wealth is acquired by deferring current consumption and diverting income into long-term investments. The savings ratios measure the amount being saved and invested.
The first one is investment assets-to-net worth ratio = investment assets / total net worth (both items from net worth sheet).
This tracks increases of income and wealth producing assets. Many people have a significant amount of their net worth tied up in their personal homes (and when that value drops like in 2008, it can be catastrophic). This ratio helps to show improvement in non-real estate assets.
Based on our previous statements, the ratio would be $165,000 (investment assets) / $298,700 (total net worth) = 55.2%. This ratio should increase over time as you close in on retirement
The second savings ratio you should track is the savings-to-income ratio. It is a simple one, and its purpose is to determine the percentage of your income you save each year. You gain the data from your cash flow statement.
Based on the previous statements, the ratio for the previous documents would be $13,500 / $79,100 = 17% of their income, which is good for normal folks. However, for FIRE people, the percentage is a little low – most FIRE folks shoot for 30% – 50% or more. The ratio of savings you need to perform is based on your overall financial goals.
Note that this ratio should increase over time, especially as you pay off debts and the mortgage. Don’t just take pay increases and increase your lifestyle – always take some (or all) of it and put it aside into savings.
Real Growth Ratios
Inflation is the killer of savings, slowly bleeding your savings down until you have nothing left. If inflation is 3%, the price of a product will double in 24 years. How do you deal with this?
You save enough and invest correctly, so your money grows faster than the rate of inflation. You should use the growth of Net worth ratio to make sure you are keeping up with inflation.
Growth of Net Worth Ratio =[(Net worth this year – New worth last year) / Net Worth last year] – inflation rate
Example: [( 298,700 – 275,000) / 275,000] – .03 (inflation rate) = 0.056 or 5.6% Net Worth growth.
Then once you retire, you follow the 4% rule, adjust for inflation, and enjoy the good times!
Think of your financial ratios as a report from your annual financial health checkup!