Financial ratios are a common tool to measure the financial health of a company. The price-to-earnings (P/E ratio) is a ratio that is commonly referenced by the financial media. The P/E ratio is a quick measurement for valuing a company that measures the current share price to its per-share earnings. A company that has a high P/E ratio is normally linked to a stock that investors have high expectations for growth. The average P/E ratio of the market is in the 25 times earnings range. A value stock will have a low P/E ratio. Ford (F) comes to mind because it has a P/E ratio of 5.
Another common ratio is EBITDA ratio. This is giving me a flashback to Accounting 101. The EBITDA ratio measures revenue with earnings. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It is believed by many financial managers that EBITDA determines the true financial health of a business.
For a business to be successful, its management needs to take stock of its financial health. For an individual or household to be financially successful, they too should take a deep dive and look at their metrics. Are there financial ratios that are relevant to personal finance?
There are many different aspects to being successful in personal finance. There are, however, far fewer variables when it comes to personal finance than the financial management of a corporation. With that, there are far fewer ratios to measure.
What should an individual investor measure to determine if their personal finances are healthy? For a business to be successful, it needs revenue. On the personal finance side, income is needed. Too much debt is negative for both businesses as well as for an individual. One sign of a healthy company is that it has many assets on its balance sheet. That is also true for individuals and the foundation of acquiring many assets starts with having a high savings rate.
Income is what drives your personal finances. Income is a key factor for those who are working to earn a paycheck. It is equally important for retirees who require income-producing investments to sustain their standard of living.
To save money, income is needed. How much should people be saving? In the 1980’s, Americans were saving 10% on average. That percentage has decreased over the decades. American’s are, however, trying to get their savings back on track. They are currently saving more than 5% on average.
While saving 10% is better than the current rate, it is not as high as it should be. In the Richest Man in Babylon, a savings rate of 10% was suggested. I do not know the average lifespan from 5,000 years ago, but I know that it was not as long as people are living today.
To find out if you are saving enough, the saving-to-income ratio is a helpful tool. To determine the saving-to-income ratio, divide household savings by the average household income. Savings include everything that is in a 401K, IRA, brokerage account, savings account, and checking. Real estate holdings such as your house should not be used. Income includes all earnings from a job, business, and side-gigs.
For example, Sarah is a 25-year-old math teacher. She has $20,000 in total savings. Her salary as a school teacher is $40,000 per year. Sarah would have a saving-to-income ratio of 0.5. Sarah would have a high savings-to-income ratio for age.
A good savings-to-income ratio for the average 30-year-old person would be 0.1. The saving-to-income should increase with age. At mid-career, a person should have a 1.7 savings-to-income ratio by age 40. At age 50, with retirement in sight, the savings-to-income ratio should be at 4.5. If a person is still employed at age 60, the savings-to-income rate should be in the 8.8 range.
The second factor consider is to measure debt. As a member of the financial independence community, I view all debt as bad. For a more mainstream approach to measuring debt, the debt-to-income ratio is a good measure.
Start with total debt. Include both good and bad debts. Calculate the totals for the monthly student loan, credit card payments, mortgage payments, and any other outstanding debt that you might pay every month. Next, calculate the total monthly income. To determine debt-to-income ratio: total monthly debt/income.
For example, Jim has $2,000 in monthly debt payments. His household income is $10,000. That would equal a Debt/Income Ratio of 0.2. That would be considered a reasonable amount of debt.
A household should never exceed a Debt/Income Ratio of 0.36. Anything above 0.37 is considered the danger zone. It is considered the danger zone because of that ratio measures if there is enough household income to cover monthly debts and other obligations. When the ratio of 0.36% is exceeded, there is less money to cover other expenses as well as for savings.
The last ratio is an important ratio for retirement planning. Every personal finance blog, forum, and publication states that people need to be saving more for retirement. How much exactly should people be saving?
The Saving Rate-to-Income Ratio is a helpful tool to determine how much a person should save for retirement. An employer match on a 401K plan should be counted. If an employee contributes 8% of their salary to their 401K and the employer provides a 4% match, the Savings Rate-to-income would equal 12%.
A good starting rate for a young employee who wants to retire early (younger than age 65) would want to start at 12% and try to increase their Savings Rate-to-Income Ratio by 1% per year. If an employee is satisfied with a more traditional age of 65, the 12% rate should be adequate if it is followed for 40 or more years of employment.
That 12% does not include interest, dividends, or capital gains. It does not include Social Security withholdings. The 12% Savings Rate-to-Income also does not include any contributions that an employee makes to a defined benefit plan.
Financial ratios are a useful tool to measure and track how healthy a household’s personal finances are. With financial ratios, they do not tell the whole story. They should be used as a helpful tool. They are useful to gain a snapshot to determine if income is sufficient, debt is at a manageable level, and if savings are high enough to cover future living expenses.
When you calculate the income, debt, and savings ratios, the results might be eye-opening. If these ratios reflect that your personal finances are not as healthy as you thought, the good news is that they can be improved. As you work to earn more, pay down debt, or save more, your efforts will be reflected in the ratios. A 45-year-old should have better ratios than a new college graduate.
Calculate these ratios every six months. A good time to run them is when you review your asset allocation. These ratios are for tracking the progress you are making. As you work to make improvements, your efforts will be reflected in these metrics.
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