How Financially Healthy Are You? Find Out Using 4 Ratios
Managing a personal budget is truly one of the more difficult parts of life. For some people, it seems as though something always comes up that quickly absorbs the extra money in the budget during times when they’re ahead. “First the water heater, now the car needs new tires, if it’s not one thing it’s another,” people may frequently say.
How is it that someone can have extra money one moment, and be short on money quickly thereafter? Perhaps the reason for this is most of us live well above our means, and our budget often doesn’t account for “just in case” scenarios. A Credit Donkey survey found that nearly 40 percent of Americans have less than $500 in their savings, and around 41 percent do not have enough of an emergency fund to cover one month of expenses.
Even if we have an emergency fund, few if any of us have money allotted for “just in case” we see something on sale while out shopping. Impulse purchases, unplanned expenses, and overspending throw curve balls into our monthly budgets. To help budget more effectively, and reduce ups and downs that cause us to have extra funds one month and not enough the next, there are a few calculations we should all perform on a regular basis.
1. Monthly surplus/monthly income
After you pay all of your monthly obligations, how much money do you have left? This is your monthly surplus and if you divide this amount by your total monthly income, you’ll get an idea of how well you manage your finances and also, an ideal percentage of that income you can put away for savings.
When calculating your monthly obligations, be sure to include everything — all of your bills, credit card bills, your house payment, groceries, and even your magazine subscriptions. For instance, a monthly income of $5,000 and monthly expenses of $4,000 would produce a ratio of $1,000/$5,000 = 20 percent.
2. Cash and liquid assets/monthly expenses
For this ratio, you want to add in all of your cash assets, like cash on hand, cash in the bank, money market account balances, and money you have in CDs. If you divide that total by the total amount of all of your monthly expenses, you’ll get an idea of how long you can sustain your household in the event of an emergency situation, like illness or job loss.
Say for instance, you have a combined total balance of $50,000 in all of your cash accounts and all of your monthly bills — your mortgage or rent, utilities, cable, internet, phone bills, car and insurance payments, groceries and any other regular monthly bills you have — total $5,000. This would produce $50,000/$5,000=10 months of funding in the event of an emergency. Many financial experts recommend a ratio of at least 6.
If you end up with a result of less than one, don’t fret as there are millions of other American households in the same boat. This simply means it’s time to focus your efforts towards savings. Bankrate recommends starting with a mini-emergency fund, where you start by saving money for one month of the bare necessities like rent and groceries. You can then build your fund from that point.
3. Cash and liquid assets/net worth
Your net worth is the difference between your assets and your debt. To calculate your net worth, add up the value of all of your assets. This includes everything, ranging from the value of your home, to the estimated value of your furniture, to all of your cash and cash assets. Subtract your debts (your credit card balances, mortgage, etc.) from this amount. There are also some online net worth calculators you can use to walk you through the process.
Once you’ve determine your net worth, calculate the quotient of your cash and liquid assets (your bank account balances, CDs, money market accounts, etc.) divided by your net worth. This determines the percentage portion of your net worth that is held in liquid form. Too high of a ratio means you could be taking too little financial risk, and you may want to examine other investment opportunities to gain the potential for higher returns.
4. Monthly debt/monthly income
This is your debt to income ratio and it helps determine how much of a lending risk you are. The lower your debt-to-income ratio, the better chance you have of receiving credit from lenders in most cases. Ideally, 36 percent is the highest debt-to-income percentage you should have. You can use an online calculator to determine your debt-to-income ratio, or you can calculate this ratio on your own by dividing your total monthly debt (credit card payments, student loans, mortgage payment, etc.) by your monthly income.