How Healthy Is Your Budget?
In analyzing a company, a quick way to review its financial health is to observe various ratios such as its Price/Earnings ratio or its Current ratio. The same can be done with your own personal financial health as well. Consider some of the following ratios to quickly check how you are doing and if there are any red flags in your personal situation.
Liquidity: Emergency Funds (3-6 Months)
Most people have heard of this particular ratio. It is important to have somewhere between 3 to 6 months of cash available to be able to handle any kind of emergency that comes up. The calculation is pretty simple: take your monthly budget and multiply it by 3 (minimum) or 6 (maximum) to know how much cash you should have in checking or savings. The more volatile your income is, the closer to 6 months you should have saved up. Anytime you have to use these funds, it is important to replenish them as soon as possible.
Solvency: Total Assets to Total Liabilities (>1.00)
Another fairly simple ratio to consider is one that makes sure you have more assets than debt. First, add up all of your assets and then simply divide by the amount of all of your debts. If you are above 1, then you are considered financially solvent and have a positive net worth. If you are negative, this isn’t the end of the world but should be a warning sign that you need to reevaluate your debt situation. Anytime you use debt, it is worth considering if you are getting an asset back in return. If you are simply consuming whatever you are using debt for, it may be time to reconsider your budget.
Consumer Debt Ratio (Max 10-15%)
Consumer debt is made up of things like credit cards, auto loans, student loans, etc. The main debt that is left out is housing, which we will get to next. Once you total up all of your consumer debt, you should divide it by your gross income. The max it should be is 10%, but if student debt is significant in the early years, 15% might be more realistic. Again this is a max number and not a target number. Driving down consumer debt is always a great way to solidify your financial situation. A ratio of 0% is always a great goal.
Housing Debt Ratio (Max 28%)
The housing debt ratio is very similar to the consumer debt ratio. Total up your mortgage, both principal and interest, and add it together with home insurance and property taxes. Take that number and divide it by your gross income. The recommended max here is 28% and applies to renters as well. In places like California, I have seen this number creep a little higher, but it is important to remember that if this number is higher, everything else must come down to match.
Total Annual Debt Payment (Max 36-38%)
This last coverage ratio is really a combination of the two above. What we are looking for here is to make sure that your debt payments don’t exceed much more than a third of your gross income. The calculation here is to take all debt payments, consumer and housing, and add them up and then divide by your gross income. The maximum you should aim for is about 36-38%.
Savings: Savings Ratio (Minimum 5-10%)
Lastly, we have the savings ratio, which is easy to calculate as well. Take the amount you are saving per year and divide it by your annual gross income. This should hopefully be at a minimum of 5-10%. Depending on your situation it may need to be higher based on what your goals are for retirement.
Financial ratios are a great way to quickly check in and make sure your finances are in order. Even just the exercise of putting them together is a great way to stay on top of all of your finances. If you want to go deeper or need help getting your ratios back in order, always feel free to reach out to one of our planners to look at your personal situation.