If you remember, I wrote back in the middle of the year about using financial ratios to analyze your performance over a period of time. I thought it would be good to revisit my ratios, see how I’m doing, and give everyone a chance to see if this sort of tracking would suit them.
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.
Our Liquidity ratio has been over 2 years for some time (thanks Mrs. 39 Months!), but it dipped in 2018 – not so much because of lack of cash, but an increase in the average monthly expenses due to some medical bills. Not a trend I want to continue.
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.
Our debt ratio continues to be 0, as we are debt free (and I intend to stay that way!)
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 savings ratio that I 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.
For the first time in our lives, our savings ratio bumped above 50% vs.Gross Income (i.e. income before taxes). Once we got the “Fire” and paid off the mortgage, it really got us pumped.
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!
Like just about everyone, our Net Worth took a hit this year (down 3.5%) due to the market. While we were diversified, and thus didn’t suffer as much as being 100% in stocks, the combination of the market and rising interest rates on our bond portfolio really gave us a hit.
Very Hope this was helpful!
Mr 39 Months