Money is a grey area for most people.
Given the chance, most people will want to avoid the topic. But this is hardly possible given the society we live in, where money is needed for daily living. Having that hard talk about money is crucial as it helps you to put things in perspective early on.
One way to make quick decisions about your finances is to use personal finance ratios.
Personal financial ratios can give you a picture of your proper financial health and progress relative to your goals.
Using personal finance ratios helps you determine where you are financially and what you can do to achieve your money goals.
These benchmarks can help you develop better money management skills in:
Let's have a look at some of the personal finance ratios you should be aware of to help you make better decisions when it comes to your money.
9 Personal Finance Ratios to Be Aware of
Also known as a percentage breakdown budget, the 50/30/20 budgeting ratio gives a breakdown of what portion of your budget should be assigned to which areas. The percentage breakdown of this ratio is -
This means the cost of your basic essential living expenses such as transportation, food, utilities, etc., should be no more than 50% of your after-tax income.
30% of your budget should be assigned to your wants. These are discretionary expenses such as eating out, entertainment or shopping, etc.
The remaining 20% of your budget should be allocated to savings and investments.
The benefit of this ratio is that it highlights the importance of keeping the mandatory costs at a level that allows you to consistently contribute to savings and invest for the long-term, while leaving ample room for wants as well.
If you want to maintain a good credit score, the credit utilization ratio helps you keep track of how you use your credit.
This ratio shows you how much of the revolving credit available to you is being utilized.
For example, if you own one credit card with a $10,000 credit limit and a current balance of $4,500, the utilization rate would be 45%.
$4,500/$10,000 x 100 = 45% Utilization
Credit utilization is a major factor in your FICO score, and accounts for 30% of how your score is calculated.
A higher credit utilization ratio negatively impacts your credit score. This is because of unhealthy reliance on debt to offset living costs. This sends a red flag to lenders who will question your ability to repay, given that you need revolving debt to get along.
The loan-to-value- ratio (LTV) is the measure of the maximum amount of a secured loan, based on the market value of the asset pledged as collateral, expressed as a percentage.
It is used to represent the proportion of an asset’s value that a lender is willing to provide debt financing against. Lenders use this ratio as a part of the mortgage approval process and for refinancing and home equity line of credit applications.
LTV is calculated as thus: LTV % = (Loan Amount / Asset Value) * 100
For homeowners, the LTV also reflects the equity you have accrued in your home, or the portion of the mortgaged property that you own.
If you're a prospective buyer, the loan-to-value ratio helps determine if you have to pay extra fees such as private mortgage insurance (for an LTV of less than 80%). This is done to reduce the risk to the lender.
It also decides if you are eligible for a home equity line of credit for already-owned properties or a refinance with a lower interest rate.
The DTI ratio calculates what proportion of your income goes to paying debt.
This is done by summing up all of your debts and dividing the total by your monthly take-home pay.
A major benefit of this personal finance ratio is that it helps you determine how much of your income will go toward paying off debt with interest. It spurs you to pay off your debt faster by raising your income, lowering your expenses, or doing both.
This ratio is used by lenders to determine your ability to repay a loan. Most lenders look for a DTI percentage below 35% total.
This means that your monthly payments are under 35% of your income.
A high DTI ratio can limit your chances of qualifying for loans, managing debt payments, or investing for your financial stability.
Your ability to quickly turn assets into cash with minimal to no principal loss is referred to as liquidity.
When you have liquid assets, you can cover unforeseen expenses like job loss, a death in the family, or a leaking roof.
The most liquid assets are those involving money.
These assets consist of:
For six months, cover your fixed monthly costs with your liquid assets.
Calculating your liquidity ratio goes like this: Liquidity Ratio= Monetary Assets/ Monthly Expenses
If you have a liquidity ratio of 6, this means your financial resources are sufficient to cover your basic expenses for the next six months, including food, rent, utilities, and a car loan.
Solvency means your ability to meet your long-term debts and financial obligations.
The solvency ratio helps you to determine if you can take care of your obligations in the event of unforeseen circumstances.
This is calculated as:
Solvency Ratio = Net Worth/Total Assets
The higher the ratio, the better your financial condition and ability to meet your loan obligations.
At a point in time, it is important to check your net worth. Our debt-driven society encourages everyone to borrow, which can put a mask on the true nature of your finances. Knowing your true net worth dispels the smokescreen around your finances, helping you take appropriate steps to grow your assets.
To do this, you can use the net worth ratio which is calculated as: Total Assets - Total Liabilities
Your total assets are what you own at their current market value. Your total liabilities are what you owe based on your debt obligations. As your assets outpace your liabilities, you will be getting wealthier and vice versa.
Having an emergency fund is vital to your financial security. It prepares you for unexpected events such as a job loss, medical emergency, repairs, etc. This ratio is used to calculate 3-6 months of your basic living expenses to know how much you need to save for unexpected events.
This is calculated by adding up your monthly basic living expenses and multiplying the amount by 3-6 months for the total amount needed.
For example, let's say your essential expenses are $1,000 a month multiplied by 3 or 6 months, and this would give you $3,000-$6000 to save as emergency funds.
It may be overwhelming to save up an emergency fund at first, but if you break it down into smaller chunks, you will be able to eventually save up enough money.
Preparing and saving for retirement can mean a long hard life ahead, and this task just got more difficult. 35% of Americans have no retirement savings at all, and millions are postponing retirement plans due to rising inflation.
Given this, many people are leaving themselves without a means to fend for themselves when they are no longer able to work.
Using a retirement savings ratio helps you know how much you need for retirement. This knowledge will help you start investing and saving for a better future.
To calculate your retirement savings ratio, you:
multiply your current living expenses * the number of years you expect to live
Also take into consideration other factors like health costs, house repairs, vacation, etc.
Be sure to diversify your retirement portfolio to ensure you are investing your money the right way. Above all, keep in mind you need to regularly check in with your retirement accounts to ensure you are earning enough towards your retirement goal.
Using ratios with money helps you keep your finances in check and manage your money better.
Personal finance ratio formulas help you keep your debt to income low, plan for retirement, and stick to a budget so you can achieve your financial goals.