February 9, 2012

Five Financial Ratios

Financial ratios are one way to do a quick assessment of how you're doing.   The 5 ratios below can give you an easy snap shot of how you're doing.   FreeMoneyFinance discussed the five financial ratios below, three of which were from The Dough Roller.

1 ) Emergency Fund Ratio (Liquid Assets/Monthly Expenses) -- The generally accepted rule of thumb is that you need 3 to 6 months of expenses in an emergency fund.

2 ) Doomsday Fund Ratio (Financial Assets/Monthly Expenses) -- How long could you last with no income at all?

3 ) Net Worth Ratio (Net Worth / (yearly income * age / 10)) -- You want this ratio to be 1 or higher.

4) Net Worth / (gross income earned since working )

5) Retirement Fund Ratio (Retirement Savings / Yearly Income) -- The goal is to retire with at least 12 times your annual income.

Here is how I come out on those 5 ratios:

1) Emergency fund = liquid assets / monthly expenses = 30 months
2)  Doomsday fund = total assets / monthly expenses = 10.5 years
3) Net worth ratio = net worth / income * age/10 = 1.2
4) net worth / gross total income = 0.55
5) Retirement fund ratio = retirement savings / yearly income = 1.65

I come out pretty well on the first four.   For the first two I used our normal spending.  However we could easily cut our spending if we paid off our home mortgage and cut back on some discretionary spending.  If we paid off our home mortgage using liquid assets then the doomsday fund would come out to over 12 years.

We look pretty bad in the last ratio because a lot of our assets are not in traditional retirement savings.  I only used our 401k & IRA account balances for that.   However I consider our real estate to be retirement investments as well.   We have a much higher % of our assets in real estate investments.  If I added those then I'd have a higher ratio there.

Personally I'm mostly focused on the #1 and #2 ratios.   I want a high amount of liquid savings / emergency fund so we can ride out any potential disasters.    I'd also like to have that 'doomsday' fund high enough to last decades.  I look at that as another measure of whether or not I'm ready to be truly financially independent.


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