Most everyone is aware of the importance of calculating our net worth for determining our financial well-being. But many of us are unaware of other easy financial ratio calculations that we can perform to get an even clearer idea of how we stand financially. The best parts of these financial ratios are that they are super easy to calculate and you can get most of the information you need right from your net worth statements! After each measure presented below, I list the percentages that experts recommend and the percentages that I recommend.
This ratio is calculated as follows:
Liquidity Ratio = Liquid Assets / Monthly Expenses
The recommended percentage of this ratio is 250% (or 2 ½ times) of your monthly expenses. The point of this ratio is to make sure you have enough liquid assets to cover yourself should an unexpected expense arise. Your liquid assets include cash, bank accounts, money market funds and CD’s that mature within six months.
An example would be if you have monthly expenses of $2,000 you would need 2 ½ times this amount, or $5,000 in liquid assets. Note that this ratio is just for calculating if you can cover an unexpected expense. I recommend a much higher ratio, 10 times your monthly expenses, for being able to handle a period of loss of income.
My Recommended Liquidity Ratio: 1000%
More on Liquidity:
- Emergency Funds 101
- How Big Should Your Emergency Fund Be?
- 6 Reasons Why You Need to Carry Cash
- Should You Use a Roth IRA as an Emergency Fund?
- Emergency Fund or Retirement First?
This ratio is calculated as follows:
Savings Ratio = Savings / Gross Income
The recommended percentage for this ratio is greater than 10%. Savings includes planned savings, retirement contributions and cash surpluses. An example of this ratio is if I have $20,000 in savings and my gross income is $50,000 per year, my savings ratio is 40%. You can also do this on a monthly basis as well; you just have to use what you save in the month as your savings amount and your monthly gross income as the denominator.
I recommend a higher savings rate. You should be saving at least 20% per month, more if possible. Doing this will teach you to keep your spending in check which will serve you well as you age and the more you save, the more it can grow and allow you to live comfortably in retirement.
My Recommended Savings Ratio: 20%+
More on Liquidity:
- Why You Should Save 1% More Each Year
- Reverse Strategy: Decreasing Contribution Percent
- Take Advantage of Retirement Catch-Up Contributions
- 2013 Roth 401k and Roth IRA Limits
- Can You Have a 401k and an IRA at the Same Time?
Housing Expense Ratio
The ratio for housing expenses is:
Housing Expense Ratio = Homeowner’s Expenses / Gross Income
Homeowner’s expenses include your mortgage payment, taxes, insurance, homeowner’s association fees, utilities, and maintenance and repairs. An example would be if your monthly gross income is $3,750 then your homeowner’s expenses should not exceed $1,312.
I think this ratio is a little misleading. I think this way because using gross income is not an accurate figure. For example, if I tell you that you make $3,750 per month and your housing expenses will be $1,312, you probably feel that you can easily afford that. But $3,750 isn’t what your paycheck is. Once you deduct taxes, Social Security, Medicare, health insurance and any contributions to your retirement plan, your monthly take home pay might be $2,500. Thirty-five percent of that is $875. That only leaves you with $1,635 versus $2,438 per month. That is a difference of $800. I would rather look at net income (take home pay) as opposed to gross income and keep the ratio between 20-25%.
My Recommended Housing Expense Ratio: 20 – 25% of net income
More on Housing Expenses:
- 16 Ways to Lower Your Housing Costs
- Current Mortgage Rates
- How to Appeal Your Property Tax Assessment
- What Percentage of Assets and Liabilities are in Your Home?
- 5 Overlooked and Expensive Home Repairs
There are two main debt ratios. The first is for non-mortgage debt:
Non-Mortgage Debt Ratio = Non-Mortgage Debt Payments / After-Tax Income
Ideally, you want to have this percentage at 15% or less. Once you hit 20% or more, you are in the danger zone. For example, if you have $3,000 in after-tax income per month, you should only have $450 in monthly debt payments. This includes credit card payments, student loan payments, auto loan payments, and personal loan payments.
My Recommended Non-Mortgage Debt Ratio: Less than 15%
The second debt ratio includes all debt payments:
Total Debt Ratio = Total Debt Payments / After-Tax Income
The recommendation for this ratio is 35% or less. Anything greater than 45% is trouble. So, if you have $3,000 in after-tax income, your total debt payments, including your mortgage should not be greater than $1,050.
Personally, I think that 35% is too high. This percentage was fine when you could count on Social Security and a pension from your employer. But now that you have to save the majority of the money for your retirement yourself, you need to save as much as possible. In order to do this, you need to keep your expenses as low as possible. This does not mean you cannot enjoy your money, but rather learn the difference between needs and wants and whether your wants really are worth it.
My Recommended Total Debt Ratio: Less than 35%
More on Debt:
- Should You Use Savings to Pay Off Debt?
- 10 Step Plan for Debt Elimination
- How to Use Snowball Debt Reduction to Payoff Credit Cards
- Turn Your Wasted Money Into a Debt Reduction Plan
- The Aftermath of Debt Payoff
What do your ratios look like? Which ones do you want to improve?