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com Analysis of Your Personal Financial Data

By Michael P. Griffin
Preparing a personal balance sheet is just the first step in getting a handle on your finances. Once you prepare a personal balance sheet, you should go one step further to identify your financial strengths and weaknesses by periodically calculating and monitoring some financial ratios and by performing other forms of simple analysis. Unfortunately, most popular personal financial planning books and college personal finance texts rarely cover the type of financial analysis you should do. Lets examine some useful personal finance ratios and metrics and where possible, Ill suggest some basic rules of thumb. Personal financial ratios are measuring devices to help better understand your financial standing. Measurement is important. If you can measure a financial relationship, you make it visible. Visibility is important because many times there are things going on below the surface that you can see. For example, a growing debt burden may be creeping up on you; soon to become a problem. Debt ratios can help make the growing debt burden visible. Unlike business finance, with its generally accepted sets of financial ratios, personal finance experts have not adopted a set of ratios. The ratios covered here are a compilation of ratios that I have used as a financial advisor, professor, and software developer. I have also done considerable research and study on the subject of personal finance ratios. However, please keep in mind that cannot be used in a vacuum; perspective is needed. Ratios need to be calculated over time so that trends can be seen. In addition, ratios need to be considered the context of your personal situation. For example, it may be quite difficult for a young couple to have a healthy current ratio as liquid assets might be marshaled for a down payment on a home. Therefore, life cycle is an important factor to consider as you review your financial ratios. The economic environment is also a factor. For example, if your net worth is increasing by 5% per year but inflation is running at 6%, then in a real sense, you are actually losing ground. Your balance sheet offers you a chance to critically review where you stand and how much progress you are making over time. Ratios assist you greatly in this analysis. Financial analysis of a personal financial situation will help you better manage your resources, develop better spending habits that are congruent with your goals, and help you minimize use of debt.

Liquidity Ratios
Liquidity ratios are useful in analyzing your ability to meet obligations when faced with a decline in income. Liquidity is also needed for sudden opportunities or crisis. For example, if you are suddenly presented with an investment opportunity for which you must act fast, you will probably look first to draw on your liquid assets. The same is true if your water heater suddenly breaks down and you need to quickly replace it. Liquid assets consist of your checking, savings, and other short-term cash-like assets. They are assets that are basically in a spendable form; easily and quickly converted to cash. Financial

experts have long held that liquid assets equal to 2 to 6 months of living expenses is an adequate amount for most people.

Basic Liquidity Ratio = Liquid Assets/Monthly Expenses

Another version of the liquidity ratio is calculated as follows:

Liquid Assets + Other Financial Assets/Monthly Expenses

While similar to the first ratio, this one provides a broader definition of assets that could be liquidated to pay bills. Financial assets include stocks, bonds, and mutual funds. Financial assets can usually be converted to cash in a relatively short period of time with little or no loss of value.

Rule of Thumb: Many experts look for at least a recommended value of 6 (months) for this
ratio.

Debt Ratios
Just about everyone has debt. The real question is do you have too much debt? The Fed considers a debt burden of more than 40% of your income an indicator of financial distress and many bankers use 36% as a rule of thumb.

Debt-to-Income Ratio Debt to Income Ratio = Total Monthly Debt Payments Divided by Total Monthly Income Rule of Thumb: Less than 40% Housing Expense Ratio Housing (Loan principal and interest + private mortgage insurance + hazard insurance + property taxes + homeowner's association dues) / by Gross Monthly Income Rule of Thumb: Housing expenses should not exceed 28% of gross income. Debt Ratio (Loan principal and interest + private mortgage insurance + hazard insurance, property taxes + homeowner's association dues + credit card payments + child support + car loans + obligations that will not be paid off within a relatively short period of time (6-10 months)) / by Gross Monthly Income Rule of Thumb: Housing Expenses plus recurring debt should not exceed 36% of gross
income.

Consumer Debt Ratio Monthly consumer debt payments (all debt payments except mortgage) / after-tax-income Rule of Thumb: This ratio should be less than 20%. A high consumer debt ratio could point to
excessive use of credit cards.

Loan-to-Value
This ratio shows the portion of the value of a home pledged for debt.

Total mortgage loan balances on primary home / by value of primary home Rule of Thumb: L-T-V of less than 80% are considered solid. Equity-to-value
This ratio shows the portion of home value owned free and clear.

Equity in home / by Value of Home

Net Worth Ratios and Other Related Metrics

Net Worth
Net worth is the purest form of personal wealth measurement. Net worth alone is a critical metric to calculate and monitor over time. If you prepare a proper personal balance sheet, you will automatically calculate your net worth.

Total Assets Total Liabilities = Net Worth Total Debt-to-Net Worth

Another metric of leverage, this ratio compares your debt to your wealth. Liabilities are synonymous with debt. Therefore, your total liability is the sum of all the money you owe.

Total of all Liabilities / Net Worth Rule of Thumb: Total debt-to-net worth should be kept below 1. Tangible Net Worth
The term tangible in finance means assets that you can touch that have a physical existence. Land, buildings, automobiles, gold, furniture, and equipment are all examples of tangible assets.

(Net Equity in Home + Tangible Assets)/Net Worth

The above ratio assumes that the value of equity in homes and tangible assets will increase with inflation. Therefore, this ratio assesses the inflation protection you have inherent in your net worth.

Rule of Thumb: A value of 1 or greater is reasonable, especially during periods of high

expected inflation.

Net Worth Benchmark

This metric is used to compare your actual net worth to a standard. The net worth benchmark assumes that your net worth is a function of your earnings and your years of earnings.

Net Worth Benchmark1 = (Your Age x Pretax Annual Household Income from all sources except inheritances) / 10

Trends
You should calculate personal financial ratios periodically like once per year as a way of monitoring your personal financial situation. Setting up a worksheet in Excel or using a product like the Personal Financial Organizer can make the process easy. Ratios like these dont mean much unless you compare them to ratios from other years. One simple strategy is to create a table containing a list of your ratios year-by-year. A table, like the one below, will help you organize and keep track of your ratios it will let you see trends. The table also includes the preferred trend over time to help you analyze your situation.

Ratio Name Basic Liquidity Ratio Debt Ratio 2

Year 1 3

Year 2 6

Year 3

Standard and Preferred trend over time Increasing over time. At least 6 months of living expenses. It is good to see this one fall. The rule of thumb is 36% or less.

40%

38%

35%

About the Author

Michael P. Griffin is the Assistant Dean at the Charlton College of Business. He is the principal of Griffin Financial Concepts, a developer of content for all forms of media including software. He has been involved in the development of many financial software packages including Office Ready Business Plans, The Personal Financial Organizer, and a line of calculators. His articles have also been syndicated for inclusion in a variety of periodicals and newspapers. For more information visit: www.griffinfinancialconcepts.com

This benchmark was introduced in the book: The Millionaire Next Door: The Surprising Secrets of America's Wealthy by Thomas J. Stanley and William D. Danko.