Financial ratios are numerical calculations designed to simplify the process of evaluating your financial strength and the progress of your financial condition. Ratios serve as tools or yardsticks to develop saving, spending, and credit-use pat- terns consistent with your goals. Calculators for these ratios can be found on the Garman/Forgue website
Basic Liquidity Ratio: Can I Pay for Emergencies?
Liquidity is the speed and ease with which an asset can be converted to cash. You can use the basic liquidity ratio to determine the number of months that you could continue to meet your expenses using only your monetary assets if all income ceases. A high ratio is desirable. For example, compare the monetary assets on the balance sheet for Victor and Maria Hernandez in Table 3.3 ($4420) with their monthly expenses in Table 3.5 ($64,786 12 $5399) using Equation (3.3):
Basic Liquidity Ratio: Can I Pay for Emergencies?
Liquidity is the speed and ease with which an asset can be converted to cash. You can use the basic liquidity ratio to determine the number of months that you could continue to meet your expenses using only your monetary assets if all income ceases. A high ratio is desirable. For example, compare the monetary assets on the balance sheet for Victor and Maria Hernandez in Table 3.3 ($4420) with their monthly expenses in Table 3.5 ($64,786 12 $5399) using Equation (3.3):
This financial ratio suggests that the Hernandezes may have insufficient mo netary assets, unable to support them for even one month (0.82) if they faced with a loss of income. According to researchers at the University of Texas, experts recommend that people have monetary assets equal to three months’ expenses in emergency cash reserves. Surveys reveal that more than half of American families do not have thatmuch savings. The exact amount of monetary assets necessary depends on your family situation and your job. A smaller amount may be sufficient for your needs if you have adequate income protection through an employee benefit program, are employed in a job that is definitely not subject to layoffs, or have a partner who works for money income. Households dependent on the income from a self-employed person with fluctuating income need a larger emergency cash reserve
Asset-to-Debt Ratio: Do I Have Enough Assets Compared with Liabilities?
The asset-to-debt ratio compares total assets with total liabilities. It provides you with a broad measure of your financial liquidity. This ratio measures solvency and ability to pay debts, as shown in Equation (3.4). A high ratio is desirable.Calculations based on the figures in the Hernandezes’ balance sheet (Table 3.3) show that the couple has ample assets compared with their debts because they own items worth more than three times what they owe. (Reversing the mathematics shows that they owe less than one-third of what they own.)
Asset-to-Debt Ratio: Do I Have Enough Assets Compared with Liabilities?
The asset-to-debt ratio compares total assets with total liabilities. It provides you with a broad measure of your financial liquidity. This ratio measures solvency and ability to pay debts, as shown in Equation (3.4). A high ratio is desirable.Calculations based on the figures in the Hernandezes’ balance sheet (Table 3.3) show that the couple has ample assets compared with their debts because they own items worth more than three times what they owe. (Reversing the mathematics shows that they owe less than one-third of what they own.)
If you owe more than you own, then you are technically insolvent. While your current income may be sufficient to pay your current bills, you still do not have enough assets to cover all of your debts. Many people in such situations seek credit counseling, and some eventually declare bankruptcy
Debt Service-to-Income Ratio: Can I Meet My Total Debt Obligations?
The debt service-to-income ratio provides a view of your total debt burden by comparing the dollars spent on gross annual debt repayments (including rent or mortgagepayments) with gross annual income. A ratio of 0.36 or less is desirable. Using data in Table 3.5, Equation (3.5) shows that the Hernandezes’ $16,400 in annual loan repayments ($12,000 for the mortgage loan and $4400 for the automobile loan) amount to 24.85 percent of their $66,000 annual income. A ratio of 0.36 or less indicatesthat gross income is adequate to make debt repayments, including housing costs, and implies that you usually have some flexibility in budgeting for other expenses. This ratio should decrease as you grow older
Debt Service-to-Income Ratio: Can I Meet My Total Debt Obligations?
The debt service-to-income ratio provides a view of your total debt burden by comparing the dollars spent on gross annual debt repayments (including rent or mortgagepayments) with gross annual income. A ratio of 0.36 or less is desirable. Using data in Table 3.5, Equation (3.5) shows that the Hernandezes’ $16,400 in annual loan repayments ($12,000 for the mortgage loan and $4400 for the automobile loan) amount to 24.85 percent of their $66,000 annual income. A ratio of 0.36 or less indicatesthat gross income is adequate to make debt repayments, including housing costs, and implies that you usually have some flexibility in budgeting for other expenses. This ratio should decrease as you grow older
Debt Payments-to-Disposable Income Ratio: Can I Pay My Debts?
The debt payments-to-disposable income ratio divides monthly disposable personal income (not gross income) into monthly debt repayments (excluding mortgagedebt). (Disposable personal income is the amount of your income remaining aftertaxes and withholdings for such purposes as insurance and union dues.) It estimates funds available for debt repayment. A ratio of 15 percent or less is desirable. A debt payments-to-disposable income ratio of 16 percent or more is considered problematic because the person is making high debt payments and quickly would be in serious financial trouble if a disruption in income occurred. In the Hernandezes’ case, their disposable monthly income from Table 3.5 is $3932.50 [($66,000 $2980 $6800 $3100 $720 $4260 $950) 12]. Their monthly debt repayments from Table 3.5 are $366.67 ($4400 12). The result using Equation (3.6) is a debt payments-to-disposable income ratio of 9.32 percent
The debt payments-to-disposable income ratio divides monthly disposable personal income (not gross income) into monthly debt repayments (excluding mortgagedebt). (Disposable personal income is the amount of your income remaining aftertaxes and withholdings for such purposes as insurance and union dues.) It estimates funds available for debt repayment. A ratio of 15 percent or less is desirable. A debt payments-to-disposable income ratio of 16 percent or more is considered problematic because the person is making high debt payments and quickly would be in serious financial trouble if a disruption in income occurred. In the Hernandezes’ case, their disposable monthly income from Table 3.5 is $3932.50 [($66,000 $2980 $6800 $3100 $720 $4260 $950) 12]. Their monthly debt repayments from Table 3.5 are $366.67 ($4400 12). The result using Equation (3.6) is a debt payments-to-disposable income ratio of 9.32 percent
Investment Assets-to-Total Assets Ratio: Do I Need to Invest More?
The investment assets-to-total assets ratio compares the value of your investment assets with your net worth. This ratio reveals how well an individual or family is advancing toward their financial goals for capital accumulation, especially as related to retirement. A ratio of 50 percent or higher is desirable. A ratio of 10 percent might be appropriate for people in their 20s, 11 to 30 percent for those in their 30s, and above 30 percent for people in their 40s. Inserting the data from their balance sheet in Table 3.3 into Equation (3.7) shows that the Hernandezes have a ratio of 0.352 or 35.2 percent. As you can see, a little more than one-third of their total assets is made up of investment assets, a typical proportion for this stage in their lives.
The investment assets-to-total assets ratio compares the value of your investment assets with your net worth. This ratio reveals how well an individual or family is advancing toward their financial goals for capital accumulation, especially as related to retirement. A ratio of 50 percent or higher is desirable. A ratio of 10 percent might be appropriate for people in their 20s, 11 to 30 percent for those in their 30s, and above 30 percent for people in their 40s. Inserting the data from their balance sheet in Table 3.3 into Equation (3.7) shows that the Hernandezes have a ratio of 0.352 or 35.2 percent. As you can see, a little more than one-third of their total assets is made up of investment assets, a typical proportion for this stage in their lives.
Other Ways to Assess Financial Progress
You can use other data from your balance sheet and cash-flow statement to help analyze your finances. Consider the assets listed on the balance sheet for Victor and MariaHernandez in Table 3.3. Do they have too few monetary assets compared with tangible and investment assets? Experts recommend that 15 to 20 percent of your assets be inmonetary form and that this proportion increase as you near retirement. Do you have too much invested in one asset, or have you diversified, like the Hernandezes? Have your balance sheet figures changed in a favorable direction since last year? Is a growing proportion of your income coming from your investments? Are you making progress toward your financial goals? If not, ask: “Am I spending money where I really want to?” “In which categories can I reduce expenses?” “Could I increase income?”
You can use other data from your balance sheet and cash-flow statement to help analyze your finances. Consider the assets listed on the balance sheet for Victor and MariaHernandez in Table 3.3. Do they have too few monetary assets compared with tangible and investment assets? Experts recommend that 15 to 20 percent of your assets be inmonetary form and that this proportion increase as you near retirement. Do you have too much invested in one asset, or have you diversified, like the Hernandezes? Have your balance sheet figures changed in a favorable direction since last year? Is a growing proportion of your income coming from your investments? Are you making progress toward your financial goals? If not, ask: “Am I spending money where I really want to?” “In which categories can I reduce expenses?” “Could I increase income?”
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