Thanks to a post on Sitting Pretty Financially, I found an interesting article that talks about personal financial ratios that we could use to analyze our financial standing.
The three ratios that the article talks about are:
- The savings to income ratio would be familiar to readers of The Millionaire Next Door
. Savings is defined as the current value of financial assets not including the family home.
- Debt to income ratio, with debt being all obligations like mortgages, car loans, student loans, credit card debt etc.
- The savings rate, which is the percentage of pre-tax income that an individual saves every year.
The article also provides guidelines for the financial ratios at different ages with the only constant being the savings rate at 12% of pre-tax income. For example, a 30-year old just starting out in life is expected to have a S/I ratio of 0.1 and a high D/I ratio of 1.7 and a 50-year old starting to think about his retirement should have a S/I ratio of 4.5 and a D/I ratio of 0.75. The assumption is that when retiring at age 65, an individual should have savings of 12 times income and no debt.
While useful as a benchmark, the personal finance ratios are as meaningless as stock ratios without a context. An individual with a very high savings rate doesn’t need anywhere close to a nest egg of 12 times income, since they are frugal to begin with. Also, I would argue that home equity should at least partially be included in the savings column as a paid-off house provides “income” in the form of a rent that would otherwise have to be paid.
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3 responses so far ↓
1 Flexo // Mar 23, 2006 at 9:23 pm
Like you said, ratios are meaningless without context. It would be more interesting to follow an individual’s ratio trend for several successive years. Is the S/I ratio increasing and the D/I ratio decreasing? If so, they’re in good shape.
2 0xcc // Mar 24, 2006 at 6:02 am
Maybe there needs to be another ratio added to that. A savings/expenses ratio.
Personally I believe that one of the most important things that everyone should be doing in their financial life is tracking their expenses. In order to be able to know how much you will need when you are retired you have to know how much it costs to support your lifestyle. Once you have a long-term (i.e. more than 5 years) view of what your spending patterns look like you can start to figure out how big your nest egg needs to be.
3 Canadian Capitalist // Mar 24, 2006 at 8:18 am
Actually, the savings/expense ratio could be (sort of) derived from the SR and S/I ratios. I couldn’t agree with you more that tracking spending is the first step (and most important step) to financial fitness. I would rate it even higher than budgeting because not only the spending patterns give a good idea of how much capital is needed, it could also reveal areas where spending could be cut.
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