Episode #34: Five Key Financial Ratios You Need to Know

Wealth Decisions Podcast Transcript for Episode #34: Five Key Financial Ratios You Need to Know

Listen to this episode on Apple Podcasts or Spotify

Welcome to The Wealth Decisions Podcast, where each week I take 15 minutes or less to discuss crucial wealth decisions and mindset hacks to help you live a richer life.

I'm your host, Brian Muller, and I've been in the financial services industry for over 25 years, and I'm also a certified life and health coach.

And I have a passion for helping people make better decisions around their money and their life.

So for the sake of time, let's dive right into it.

In today's episode, we're going to be talking about the five financial ratios you need to know.

When it comes down to your health, there's certain things that your doctor looks at.

But when it comes to your finances, there's different ratios that can determine how healthy your finances are.

And we're going to explore some of those through the lens of these financial ratios that can give you a clearer picture of your financial well-being.

So let's start the episode with a question.

How do you know if you're financially healthy?

Is it a balance in your bank account?

Is it the car you drive?

Or is it something, you know, less visible, but maybe more fundamental?

The truth really is with financial health isn't just about how much money you have, but rather how well you manage what you have.

That's where financial ratios kind of come in.

These are tools that, you know, financial advisors and economists use to assess the financial health of individuals, businesses or even entire economies.

Today we're going to cover five key ratios that can give you a snapshot of your financial health.

We're going to look at debt to income ratio, your savings rate, your emergency fund ratio, your net worth to income ratio and your solvency ratio.

So let's break them down one by one.

Let's start with the debt to income ratio.

This is a ratio that compares how much you owe each month to how much you earn.

It's really a key indicator of your ability kind of to manage your monthly payments and repay debts.

So to calculate your debt to income ratio, you add up all your monthly debt payments and divide them by your gross monthly income.

Multiply that number by 100 and you've got your debt to income percentage.

So for example, if your monthly debt payments total $1,500 and your monthly income is $5,000, your debt to income ratio would be 30%.

That's looking at your debt payments divided by your monthly gross income times 100, and that gives you that number.

Generally, a debt to income ratio of 36% or less is considered healthy.

And if you're above 43%, it might be time to take a serious look kind of at your debt management strategy.

So now let's talk about number two, which is your savings rate or savings ratio.

This is the percentage of your income that you're setting aside for the future.

It's a key indicator of your ability to build your wealth over time and save.

You know, to calculate your savings rate, you just divide the amount you save each month by your monthly income, and then multiply that number by 100.

So, for instance, if you have $500 out of a $4,000 monthly income, your savings rate would be 12.5%.

Financial experts often recommend saving at least 20% or higher.

If you're below 10%, it might be time to look for ways to boost your savings rate.

Now let's move on to the emergency fund ratio.

This is a ratio that tells how long you could cover your expenses if you lost your income.

It's your financial safety net.

And to calculate this, you divide your emergency fund balance by your monthly expenses.

So if you have 12,000 in your emergency fund and your monthly expenses are 4,000, your ratio would be 3.

So an emergency fund ratio means that you can cover your expenses for three months if you lost your income.

And most financial advisors recommend having at least three to six months of expenses saved.

So in this example, you'd be in pretty decent shape, but on the low end of the ratio.

If you're retired, though, you should have somewhere between 9 to 12 months in emergency account.

So your savings emergency fund ratio should be somewhere between 9 and 12.

Now let's look at your net worth to income ratio.

This is a ratio that compares your net worth, which is your total assets minus your total liabilities, to your annual income.

And it's a good indicator of your overall financial progress.

For instance, if your net worth is 200,000 and your annual income is 80,000, your ratio would be 2.5.

This means your net worth is two and a half times your annual income.

And as a rule of thumb, aim for a ratio equal to your age divided by 10.

Now it's different for everyone, so don't get discouraged if this ratio is not where it needs to be.

But if you're age 30, you should shoot for a ratio of 3.

If you're age 50, aim for a ratio of about 5.

Next up, we're going to look at the solvency ratio.

You know, obviously, liquidity is very important having an emergency account, and that focuses more on your short-term financial health.

Solvency looks at your long-term financial stability.

It measures your ability to meet all of your financial obligations if you were to liquidate all your assets.

And to calculate the solvency ratio, you just divide your total assets by your total liabilities.

So, for instance, if your total assets are 500,000 and your total liabilities are 200,000, your solvency ratio would be 2.5.

A solvency ratio above 1 means you have more assets than liabilities, which is a good thing.

Obviously, the higher the ratio, the more financially stable you are in the long term.

But a ratio below 1 indicates that you owe more than you own, which is a red flag for your long-term financial health.

Obviously, when you're young, you're going to have a ratio below 1.

But the idea is to eventually get that ratio to be maybe above 1.5 or 2 or 3.

And eventually have zero debt and zero liabilities as part of your financial picture.

So if you put it all together, imagine you've calculated all these ratios and you found out that you have a debt to income ratio of 35%, savings rate of 15%, an emergency fund ratio of 4%, a net worth to income ratio of 2.5, and a solvency ratio of 2.5.

What does this tell us?

Well, if your debt to income ratio is under the 36% threshold, which is good, but there might be room for improvement.

Your savings rate is decent, but could be higher.

Your emergency fund could cover four months of expenses, which is really solid, but you could increase that to cover six months.

And your net worth to income ratio is healthy for someone if this was someone in their mid to late 20s.

Overall, just having an idea of what some of these financial ratios are for your particular situation is just going to give you an idea of whether you're on track and show you ways to improve upon your financial health.

And you might want to focus on reducing debt or increasing your savings rate or increasing your emergency fund kind of to get your financial health back on track.

But always just remember that ratios like this, they're just guidelines.

They're not hard and fast rules.

Your personal situation might call for different targets.

It really depends on each and everyone's particular situation.

The key is to kind of to track these, you know, track your net worth, track your savings rate and set goals and targets for how much you want to improve in the year ahead.

If you don't have a grasp of your finances and have some type of financial goals, you know, it's not just about trying to look at your investments and make the best investments to increase your net worth.

It's about looking at all the things that make up financial health.

And that's not just your assets and your investments.

It's also your liabilities.

If you don't like doing math and you'd like these ratios calculated for you, and as well as a number of other ratios to give you an even clearer picture of your financial health and where you're at and where you're going, I'd be happy to do a complete analysis for you using a service that I have access to from a company called Elements.

Listen to this episode on Apple Podcasts or Spotify


-Brian D. Muller, AAMS® Founder, Wealth Advisor

Momentous Wealth Advisors in a fee-only fiduciary advisory firm

Disclaimer: This material is for informational purposes only and should not be construed as investment advice. Past performance is not indicative of future results. Investors should make investment decisions based on their unique investment objectives and financial situation. While the information is believed to be accurate, it is not guaranteed and is subject to change without notice.

Investors should understand the risks involved in owning investments, including interest rate risk, credit risk and market risk. The value of investments fluctuates and investors can lose some or all of their principal.

Always consult with a qualified financial professional before making any investment decisions.