How do you know if you’re doing well financially? Can you see warning signs that indicate you may in potential trouble? Financial ratios can be used to understand how you’re currently doing with your money. This is important, because if you don’t know where you are currently, it’s difficult to figure out how much more work you need to do to reach your goals. Here are 3 ratios that give you an idea of your financial health.
Emergency Fund Ratio
Most experts agree that you should have an emergency fund. This ratio helps us understand how well you’d be able to withstand a loss of income. This can come from a variety of reasons, including a job loss, disability, or other event that prevents you from earning money.
This ratio is calculated by dividing the amount of cash in savings by your monthly expenses.
So if you have $2,500 saved up for an emergency, and you have monthly expenses of $3,000, then your emergency fund ratio is calculated as follows:
$2,500 / $3,000 = .83 months
In this case, your emergency fund wouldn’t even be able to hold you up for a single month!
As far as the recommended size of the emergency fund, everyone has different opinions. Some say it should protect you for 3 to 6 months, while others say it should even be big enough to last for an entire year.
Every person’s situation is different. If you’re confident in your ability to find a new job after you’ve been fired, then you may only need a 6-month emergency fund. However, if an unexpected illness can keep you from working altogether, you may want to consider building an emergency fund that is big enough to cover your expenses for a year.
Monthly Debt Repayments to Monthly Gross Income
If you’re shopping for a mortgage, this is one of the ratios that lenders use to determine if you’ll be able to get a loan at the best interest rates.
(monthly housing costs + other monthly debt payments) / monthly gross income
This number should be less than 36 percent. And included in housing costs are mortgage principal, interest, taxes, and insurance. Other monthly debts can include credit card and car payments.
So suppose your housing costs are $1,200, car payments are $300, and credit card payments are $50. For salary, let’s say you make $4,000 a month.
Putting these numbers into the formula, we come up with this calculation:
($1,200 + $300 + $50) / $4,000 = 39%
In this case, you’ve exceeded the target and have too much debt for your income. But if you sold your car and used the money to buy a used car with the cash, you’d be able to both get rid of the car payment, and pay off the credit card.
This would reduce your debt ratio to 30%, allowing you to qualify for the best interest rates. The good thing about this ratio is that it can bring a dose of reality to your decisions about how much debt to take on.
The Savings Ratio
Everyone knows they should save. This ratio shows you how much you’re saving, as a percentage of your gross income.
annual savings / annual gross income
In determining your savings amount, you can include both personal savings, and employer contributions such as 401k matching contributions.
So let’s say you earn $35,000 a year, save $5,000 in your 401k each year, and your employer matches with $200.
($5,000 + $200) / $35,000 = 15%
In this example, you’d be saving 15 percent. Yet financial experts also have different opinions as to how big this ratio should be. Should it be ten percent? Fifteen? Twenty?
In my opinion, this number would depend on several factors, including when you start saving, when you plan on retiring, and the rate of return you think your investments will earn.
One thing can be certain though. It’s unlikely that you’ll reach your goals if your savings rate is zero!
Have you looked at your finances using these financial ratios?
Photo by Andres Rueda