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What are the 10 personal finance ratios that will help you build wealth and increase your financial literacy?
- Liquidity ratio
- Targeted net worth ratio
- Current ratio
- Liquid assets to net worth
- Savings ratio
- Debt to asset ratio
- Debt to income ratio
- Solvency ratio
- Debt servicing ratio
- Investment allocation ratio
What are personal finance ratios?
If you’ve read even just a few articles here at The Ambitious Dollar, you know that one of our favorite sayings is if you can measure it, you can manage it. And, while it may be cliche, it’s true.
Personal finance ratios are one such way to help you measure your financial health. They serve as helpful benchmarks we can all use to assess how we’re doing financially. And once measured, we can use that information to help us plan for, develop, and ultimately meet our goals.
Without further ado, here are the 11 personal finance ratios to help you build wealth.
1. Liquidity ratio
Liquid assets/monthly expenses
You can find your liquidity ratio by taking your liquid assets divided by your monthly expenses. If you use a budget or net worth tracker, like Personal Capital, this ratio will be very easy to calculate.
What counts as a liquid asset? Generally, a liquid asset is an asset that can be converted to cash within 24 hours. Some of the most common liquid assets are:
Monthly expenses include everything you’re on the hook to pay each month, for example:
The liquidity ratio basically tells you how long you can cover your monthly expenses with liquid assets. If you have a liquidity ratio of 3, for example, it means that your liquid assets could cover your monthly expenses for 3 months. This ratio is sometimes referred to as an emergency fund ratio.
2. Targeted net worth ratio
Age x (pretax income/10)
This ratio hails from one of the best personal finance books out there, The Millionaire Next Door. The targeted net worth ratio helps you set goal posts for what your net worth should be at a particular age, given a specific salary.
What’s net worth? Net worth is basically a snapshot of your overall financial health. It’s calculated by taking your assets minus your liabilities. Total net worth accounts for both liquid and fixed assets and liabilities. This is in contrast to the liquidity ratio mentioned above which only accounted for liquid assets.
Common assets (both liquid and fixed) include:
- Home value
- Checking and savings accounts
- Valuable possessions
Common liabilities include:
- Credit card debt
- Student loan debt
Targeted net worth ratio example
Let’s go over an example. Let’s say you’re 30 years old and have a pretax income of $60,000. According to the targeted net worth ratio, your calculation would be: 30 x ($60,000/10) = $180,000. Thus, at age 30 with a pretax salary of $60,000, you should be aiming for a net worth of $180,000.
3. Current ratio
Short term cash assets/short term liabilities
The current ratio essentially spells out your ability to pay off short term debt at a moment’s notice. If this seems very similar to the liquidity ratio, you’re aren’t wrong. The major difference is that the monthly expenses used in the liquidity ratio may still account for longer term liabilities, which are not accounted for in the current ratio. In the current ratio, only short term liabilities are factored in. Your current, short term liabilities include debt repayments due in the current year – such as monthly credit card bills.
4. Liquid assets to net worth ratio
Liquid assets/net worth
The liquid assets to net worth ratio shows what portion of your total net worth is available in cash and cash equivalents (i.e. liquid assets). Having a low liquid assets to net worth ratio would mean that a majority of your assets are tied up and not easily accessible. Having a high liquid assets to net worth ratio is just the opposite – meaning most of your assets are available and could be quickly converted to cash.
It’s in your best interest to strike a balance of liquidity with your assets. You certainly don’t want to have too much cash lying around because you want your money to be working for you. However, it’s also a good idea to keep some portion of your assets liquid for all the unexpected events that life can throw at you. An ideal amount of assets to keep liquid is whatever you require to pay for 3-6 months worth of expenses.
5. Savings ratio
The savings ratio spells out what fraction of your income goes directly into savings. The term savings here is used in a general sense, and should include all funds you are planning to hold on to or grow for the long term:
- Savings accounts
- Retirement accounts
- Long term individual investment accounts
A good rule of thumb is to save 15% of your pretax income for long term/retirement savings.
6. Debt to asset ratio
Annual debt repayments/total assets
Your debt to asset ratio shows you how much debt you have compared to how much you have in assets. In general, the lower your debt to asset ratio, the better. However, most of us incur debt in some form, such as through a mortgage, student loans, or auto loans. In general, keeping your debt to less than 40% of your total assets is best. At a 40% debt to asset ratio, it means that for every 40 cents of debt, you have 60 cents worth of assets.
7. Debt to income ratio
Annual debt repayments/gross income
Similar to the debt to asset ratio is the debt to income ratio. However, instead of comparing your level of debt to your total assets, you compare it to just your salary. A healthy debt to income ratio is 35% or below. At a 35% debt to income ratio, it means that for every 35 cents of debt, you have 65 cents of income.
Having a higher debt to income ratio could indicate that you are over leveraged. It also means that if you were to seek a loan, you may be charged a higher interest rate or denied outright.
8. Solvency ratio
Net worth/total assets
The solvency ratio helps you determine if you could pay off all existing debts by selling off or cashing in all of your assets. Remember that net worth equals your assets minus your liabilities. Note that this solvency ratio accounts for all of your assets, both liquid and fixed.
In general, we take on debt to acquire assets that will be of greater value than the debt itself. For example, you take on a mortgage with the intention that the home’s value will be greater than the cost of your debt. So, the higher your solvency ratio, the better. It means that the value of your assets is greater than any corresponding liabilities.
9. Debt servicing ratio
Monthly housing costs/gross monthly income
The debt servicing ratio is sometimes referred to as the housing expense ratio. This ratio calculates what your monthly housing costs are in relation to your gross (pretax) monthly income. It’s also what lenders will look at to determine how capable you are of paying your mortgage and associated housing costs. As a good rule of thumb, it’s best to keep your debt servicing ratio at 28% or less.
10. Investment allocation ratio
120 – age = % or your portfolio allocated to stocks
The investment allocation ratio helps you determine how much of your retirement investment portfolio should be allocated to stocks vs bonds at a given age. It follows the logic that when you’re young (and have time in your favor) you can invest more aggressively in stocks with the ability to withstand higher levels of risk. But as you age and have less time to recoup any potential losses from more risky investments, you should allocate more of your portfolio to bonds.
Thus, the investment allocation ratio is calculated by taking 120 minus your age, and that equals the percentage of your portfolio that should be allocated to stocks.
Investment allocation ratio examples
For example, if you’re 30 years old, you would take: 120-30 = 90. Thus 90% of your portfolio should be allocated to stocks and the remaining 10% would be allocated to bonds.
In contrast, let’s say you’re 55 years old. Then you would take 120-55=65. Thus 65% of your portfolio should be allocated to stocks and the remaining 35% would be allocated to bonds.
However, it’s important to remember that this ratio is a good benchmark to reference, but shouldn’t be taken as gospel. It serves as a good rule of thumb to help you allocate your portfolio. But, you’ll also want to consider your individual goals, risk tolerance, and diversification.
The bottom line
Keep in mind that all of these ratios are tools to help you assess your overall financial health, manage your money, and help you achieve your goals. But these tools can’t make any decisions for you. It’s up to you to use the data they provide in the context of your specific situation.
Having a higher debt to asset ratio isn’t always a bad thing if you’re taking out a loan to invest in your future. Having a lower net worth than what you calculated with your targeted net worth is no reason to despair. Take all of these ratios with a grain of salt and use them to the extent that will help you achieve your goals.