When reviewing the financial health of a
company, it's common to look at financial ratios, such as earnings
per share, price/earnings ratios, book value, and total return.
The reason financial ratios are so popular is they give you a
means to evaluate financial information, while allowing you to
track changes over time.
Consider using the same concept to assess
and track your personal financial situation. At least annually,
prepare a net worth statement and then calculate various financial
ratios. Comparing those ratios over time will help you assess
whether you are making progress toward your financial goals.
You should start by preparing a net worth
statement, which lists all your assets and liabilities, with the
excess representing your net worth. Assets should be valued at
the price you would obtain if you sold them now, not the amount
you paid for them. You'll also want to list your annual income
for ease in calculating some of the ratios.
Now, ask yourself the following questions
about your finances:
- Has your net worth
grown by more than the inflation rate?
Calculate the percentage growth in your net worth over the past
year and compare that to the inflation rate. To make progress
toward achieving your financial goals, your net worth should
increase by more than the inflation rate. With recent declines
in the stock and housing markets, you may see short-term declines,
but make sure you are making progress over the long term.
- What is your ratio
of assets to liabilities?
A ratio of less than 1 indicates you
have more liabilities than assets - a negative net worth. If
that is the case, take active steps to reduce your liabilities.
This ratio should increase over time, which indicates you are
reducing debts.
- What is the trend in
your liabilities?
Review the amounts and types of debts
outstanding. Mortgages are typically used to purchase a house
or other items that may appreciate in value, so they are considered
"good" debt, as long as the amounts aren't excessive.
Credit card balances and auto loans are used to finance items
that typically don't appreciate in value and should be kept to
a minimum.
- What percentages of
your assets are liquid and nonliquid? Nonliquid assets include
items like your home, other real estate, jewelry, and works of
art. Although they may increase in value over time, they can
be difficult to sell quickly at full market value. Liquid assets,
such as bank accounts and stocks, are more easily converted to
cash. You want sufficient liquid assets to cover financial emergencies.
- What is your savings-to-income
ratio? For this ratio, your savings equals all assets
designated to help fund your retirement. It typically won't include
your home, since you will probably live there after retirement.
First, you need to decide what this ratio should equal at retirement.
It is basically the amount of savings you want at retirement
age, preferably determined after a careful analysis of all appropriate
factors, divided by your annual income. For instance, if you
want retirement assets equal to $2,000,000 when you retire and
you currently earn $100,000, you would need a savings-to -ncome
ratio of 20 when you retire. You might then develop benchmarks
over your working years to help you gauge whether you are on
track to achieving that goal.
- What is your savings
rate? Calculate what percentage of your income you are
saving on an annual basis. Typically, you'll want to save a minimum
of 10% a year. This would include 401(k) contributions and individual
retirement account contributions. If your employer matches your
401(k) contributions, you can include those contributions as
part of your annual savings.
- How have your investments
performed? Now may also be a good time to thoroughly analyze
your portfolio's performance over the past year. Measure the
performance of each investment, comparing it to an appropriate
benchmark. Also calculate your overall rate of return and compare
it to your targeted return.
