Four ratios to help keep your personal finances on track
When you’re managing your personal finances, you may come across ratios you don’t understand. But some of them can make it easier to get your finances in order, and, with a little organization, you can calculate them yourself. Knowing how to use these ratios can help you achieve your financial goals.
Getting your finances in order
If you want to organize and better manage your finances, you’ll need to start by assembling and organizing your financial data, including:
- Bank account numbers and history
- Credit card numbers and transactions
- Mortgage and rent payments
- Other loans, bills, and things you own
Then you can start to create your budget or cash flow statement (to see how much cash you have left over every month) and balance sheet (to see everything you own compared to everything you owe). These documents will make it easy for you to calculate the key personal finance ratios. They’ll also help you measure progress toward your financial goals, if you check them periodically and keep them up to date.
While there are many ratios out there that help determine your financial well-being, these four are most used by the financial community to assess credit worthiness and can help you keep track of your financial condition in a meaningful way:
- Emergency fund ratio
- Savings ratio
- Debt-to-income ratio
- Debt-to-assets ratio
Emergency fund ratio
The emergency fund ratio helps you understand how prepared you are for a financial emergency. What would happen if you lost your job tomorrow? Could you continue to pay your bills while you searched for a new job?
Calculate the emergency fund ratio as follows:
|Emergency fund ratio||Emergency savings (cash or cash equivalents) ÷ monthly expenses|
The emergency fund ratio tells you how many months’ worth of expenses you have set aside in an emergency fund. If you have $15,000 in an emergency fund and your monthly costs total $3,000, your ratio comes out to 5.0, or five months of expenses.
How many months’ worth of expenses should you have accumulated in your emergency fund? That’s a personal decision based on how high your bills are, how stable your employment is, what your other investments are, and other details. But generally, you’ll want to think about how long it could take you to get a new job. Use that as a goal—for example, three to six months. Calculate your ratio once per year to see the progress you’ve made toward your goal.
Your savings ratio tells you the percentage of your total income that you’re putting toward savings. You may want to include long-term investing, such as retirement, in your savings total. Or you can calculate it both ways—one with just savings and one with just long-term investments—to make sure you’re contributing to both goals.
You can calculate using this formula:
|Savings ratio||Monthly savings and/or long-term investing ÷ monthly total income|
You could also calculate using annual figures, if you feel that’s more appropriate for your situation (e.g., if your income fluctuates throughout the year).
Look for ways to increase your savings ratio.
- Increase your savings when you get a raise.
- Save part of any bonus or gift you receive.
- Reduce your expenses to free up money that can be saved or invested.
Finding ways to increase the interest you earn on your savings can help boost your overall savings, even if it doesn’t affect your savings ratio.
If you’ve ever gone through the process of applying for a mortgage, chances are the lender put your debt-to-income (DTI) ratio under a microscope. Your DTI ratio shows how much you’re paying toward existing debts compared to your income. Your chance of getting approved for a new loan decreases if too much of your income is going toward loans or credit cards.
|Debt–to–income ratio||Monthly debt payments ÷ monthly total income|
There are two kinds of DTI: front end and back end. Front-end DTI focuses on how much of your income goes toward housing expenses—mortgage or rent, real estate taxes, and homeowners insurance. Back-end DTI expands to include all your debt, such as credit card balances and personal loans. Lenders prefer low ratios—both front end and back end—because that implies you’re less likely to have trouble paying off your debt. A DTI ratio of less than 43% is considered good; anything higher puts you at risk of not getting approved for a loan.
Your debt-to-assets ratio compares how much you own to how much you owe. It’s like DTI, but instead of looking at your income to pay off debt, it looks at the assets you could use instead. If you lost your job, you’d still be on the hook for paying down your loans, so the lender may want to know if you have assets you could sell to make those payments (in place of your lost income).
|Debt–to–assets ratio||Total liabilities ÷ total assets|
The lower your ratio, the better because that means you own more than you owe. When you calculate your debt-to-assets ratio, use that number as a starting point to try and improve. You can do that by lowering your outstanding debts, increasing your assets, or both.
Use financial ratios to measure progress
There isn’t one correct number for any of these ratios, although a quick online search will yield plenty of opinions as to what’s “right”—but what’s right depends on your situation. You can use these ratios to tell you whether you’re advancing toward your goals. Establishing baselines and periodically updating is critical to reaching your financial milestones.
The most important takeaways for you are to:
- Organize your finances
- Calculate your starting points
- Create your goals
- Periodically recalculate your ratios to measure your progress
This content is for general information only and is believed to be accurate and reliable as of the posting date but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made herein.