By: Dr. James Philpot
Professional athletes are constantly evaluated by their numbers. A quarterback has a completion percentage, a pitcher an ERA. So how are your personal financial numbers? In my previous column (Sept. 27), I discussed the mechanics of constructing a personal balance sheet. In this column, I address common financial ratios for evaluating your personal balance sheet.
As in sports, ratios allow us to summarize two or more numbers into a statistic that we can interpret and use in financial decision making. Typically we compute a financial ratio from our balance sheet, then interpret it relative to a common benchmark and/or our own financial goal or position in life. Four useful numbers in evaluating your balance sheet are: net worth, debt-to-assets ratio, emergency fund ratio and the investment assets-to-gross pay ratio.
The only absolute dollar value among our four measures, net worth equals total assets minus total liabilities. Net worth represents the total value of equity an individual or family has accumulated and is often the first stop for analysis by professional financial planners, with higher always preferred to lower. The Federal Reserve’s 2013 Survey of Consumer Finances reported that the median household net worth in the U.S. was $81,200, down slightly from the previous survey in 2010.
The proper way to evaluate net worth is relative to your financial goals and position in life. If you are 62 years old and planning for a long retirement, $81,200 is a troublingly low net worth because this amount will not support much of a retirement. Conversely, let’s say you are a 26-year-old medical resident with negative net worth (perhaps due to student loan debt). In this case even a reasonable negative net worth is not troubling, because you are young and have high expected earning capacity to build net worth. Net worth grows when we spend less than our take-home pay and/or when we invest in appreciating assets.
The debt-to-assets ratio indicates the proportion of our total asset value claimed by all of our creditors and equals total debt divided by total assets. Financial planners consider lower values of this ratio to be better. Ideally as we age, we will pay off student, home and other loans and also have invested in appreciating assets — thus reducing the value of this ratio over time.
The emergency fund ratio measures our ability to use cash assets to weather a short-term financial setback like a job loss or unexpected expenses. This ratio is computed as total cash assets divided by expected monthly expenses, and the output unit is number of months. Most experts recommend 3-6 months as a benchmark for this ratio, as it allows continuation of a standard of living for a reasonable period of time.
Finally, the investment assets-to-gross pay ratio measures progress toward a long-term savings goal like retirement. This ratio equals total cash and total investment assets divided by annual gross pay. Planners interpret this ratio as an index, with a larger number indicating better goal progress. For example, in evaluating a 30 year-old’s retirement savings, a ratio value of 0.6-0.8 is reasonable; a 55 year-old’s value should be closer to 10.
These ratios can be computed annually and compared to their prior year’s values to mark your progress toward financial goals.
This article appeared in the November 28th edition of the News-Leader and can be accessed online here.
Dr. James Philpot is a certified financial planner and is associate professor of finance at Missouri State University.