We all know the importance of metrics and data driven decisions. Specially in today’s world, everything is driven by data, big data or small.
Why should personal finance be left behind? Just saving and investing money does not mean much if we are not able to quantify our financial situation and be able to improve it year over year. So lets look at some of the metrics that we can develop or borrow from other financial scenarios.
There are many financial terms and metrics for evaluating company fundamentals and corporate performance. We can take a small subset of that and use them to measure the health of our finances.
These ratios and metrics really give you a picture as to where you stand, what will happen in a worst case scenario (lets say the stock market goes down) or you lose your job.
It is like your annual health checkup, you may feel alright but you don’t know fully what your body is going through internally.
Without much more introduction, let me explain the 5 key metrics I use to keep track of my finances. They have told me stories that I did not know without calculating them.
This is the most obvious and most popular one. There are different viewpoints regarding this, some people say its only a vanity number yet others think it summarizes your financial position.
In short, Net worth is all assets you have minus all liabilities you have to service.
So if you have $1000 of assets but owe someone $200, then your net worth is $800.
What to include in the assets is also controversial. Some people include their home value, while others will say home is really not an asset.
My view is if you are not going to stay in the home throughout your entire life, then you can count its present value (or at least purchase value) as the asset price. The liability section will account for the mortgage balance you have.
This Net worth number may sound like a vanity or it can give you a milestone to reach. For example, for many people reaching the first million in Net worth is a big deal.
A positive net worth signifies healthy finances, on the other hand a negative net worth means trouble as the person is over-leveraged.
OK so you have a positive net worth and want to celebrate. Not so soon.
In reality, majority of your asset may be made up of not-so-liquid instruments like house, cars, jewelry etc. Moreover your liabilities may be mostly short term debt like credit cards. Lets take some numbers.
You live in a $300,000 house, and has only $1000 cash. You have a mortgage of $250,000 and $25,000 credit card debt. What is your net worth?
Net worth = $300,000 + $1000 – $250,000 – $25,000 = $26,000.
So you have a positive net worth, mainly due to the Home Equity trapped in your house.
However the cash you have is not enough to pay your credit card bills or possibly even the monthly minimum amount (after other expenses). This can cause trouble or through interest charges can slowly eat away the net worth and push it towards negative.
Hence it is important to have a cash cushion to cover your short term obligations. And short term obligations may not mean only credit card debt, they could be impending quarterly taxes, property taxes, insurance premiums and any other short term debt. Typically all payments to be made quarterly or annually within the next one year can be added up as short term obligations.
The Quick Ratio is then calculated by:
Quick ratio = (Cash and cash equivalents) / (total short term obligations)
With a Quick ratio of above 1, you know your finances are well equipped to cover upcoming obligations.
Personal Finance Equity is really the Net worth that we calculated first.
Lets say in the positive net worth, you have a mortgage in terms of a long term liability.
But think of a dire situation, when you are asked to pay off the debt at a very short notice. Such emergencies can be losing a job and not able to pay the monthly payment. The lender may demand a complete pay-off or a short sale of the home.
For example repeating the earlier example in section Quick Ratio:
Net worth = $300,000 + $1000 – $250,000 – $25,000 = $26,000.
Here the debt of $275000 cannot be covered with the Net worth.
But lets say you also have $350,000 of investments in long term accounts like retirement portfolios. Now your net worth is $376,000 which if worst comes to worst, can be used to pay off all your debts and save you from foreclosure or bankruptcy.
This can be measured by yet another useful ratio.
Debt/Equity ratio gives how much of your net worth is leveraged. In the above example with $350,000 of investments,
D/E ratio = ($250,000 + $25,000) / $376,000 = 0.73
D/E ratio below 1.0 is safer as you know you can be debt-free if you want, though you need not liquidate your investments immediately if they are earning more than the interest on your debts and you have a good Quick Ratio above 1.0 to cover your immediate payments and obligations.
Since we are already talking about dooms day, it cannot be complete without the concept of emergency funds. Almost every personal finance book or article starts with this concept. But there is a large deviation in the range of the amount to be saved for emergency fund, some say 3-6 months, 1 year or even just a set amount.
Lets approach this as a scientific ratio like we have done so far.
We will calculate how many months you can survive covering your true expenses if you lose your income.
Emergency coverage = (Emergency fund value) / (monthly living expenses + monthly payments)
Note that monthly payments may not mean only mortgage or car payments, it should also account for monthly share of any annual obligations like taxes, insurance etc. Typically it should not affect your lifestyle (barring non-essential and lavish expenses) if you have to spend out of your emergency fund these many months.
The Emergency Coverage directly tells you how many months can be covered by the reserve fund. It is an individual choice to select the number, but typically 6 months is a good norm.
So far all the ratios indicate the current state or health of your finances. None of them talks about or helps grow the Net worth.
The savings ratio is pretty simple and easy to guess from its name. How much are you saving from your take home pay? It could mean saving for long term investments like retirement funds, children education fund or general investing.
However it should exclude savings done towards goals which are ultimately expenses in the short term – vacation, down payment of a car or house, or for meeting upcoming obligations.
The real savings should contribute to growing your Net worth on a year on year basis for a long term.
Savings ratio = (money saved away per month for retirement and investments + principal part of mortgage payment) / (take home income per month)
If the numerator includes amounts which are deducted pre-take-home like 401k, then it may make sense to consider a gross income as the denominator.
The Savings Ratio indicates growing net worth, and can be turned into a goal – for example I will achieve a 20% savings ratio this year.
These five ratios can be used to monitor personal finance health, and growth of net worth in the long run.
Also the simplicity of these ratios make the math very easy, you can also set these up in Excel and just update the variables on a monthly or yearly basis.
Finally these ratios with the recommended values give you the peace of mind. The following set of recommendations are a good thumb rule.
- Net worth > 0 [choose your goal or dream here]
- Quick ratio > 1.0
- Debt/Equity ratio < 1.0 [0.5 is even better]
- Emergency coverage > 6
- Savings Ratio > 20%