Financial Ratios You Need to Know

Inside: Money ratios can be a good indicator of your financial health. Find out how to calculate yours.

Numbers are wonderful things. They reveal truths and tell stories, they can make you happy or want to cry.

Like it or not, math is everywhere.

Wait! This won’t be difficult.

Even if you are math averse, you probably use it all the time: cooking, knitting, woodworking, or balancing your budget. I use it most mornings making oatmeal! (1 part oats to 2 parts water)

Just as there are ratios to making oatmeal or figuring out dimensions for a table, there are financial ratios that can reveal our financial health and guide our decisions.

Liquidity Ratios

Liquidity ratios are financial ratios that measure how much cash, or liquid assets, we have available.

Emergency fund ratio

The emergency fund ratio is also referred to as the liquidity ratio. It indicates how ready your finances are to handle an emergency such as job loss or unexpected expenses.

Financial planners generally suggest having 3-6 months of necessary expenses saved for your emergency fund. Others suggest only one month of expenses and some say 12 months. It really varies depending on your personal situation, though aiming for at least 3 months necessary expenses is a good goal. Necessary expenses would be your bare-bones budget that would keep you fed, housed and employed. The ratio is

Emergency ratio = (cash or cash equivalents) / (monthly necessary expenses)

If your emergency ratio is 3 or greater (you have 3 months basic expenses saved), you are in good shape. Otherwise, if you are starting from scratch, work up to at least $1000 and go from there.

Current ratio

Usually you hear about the current ratio when talking about companies, but this ratio can also be used when evaluating your own financial health.

The current ratio measures your ability to meet short-term obligations, where short-term is 1 year or less.

Current ratio = (cash or cash equivalents) / (short-term liabilities)

In the equation, cash and cash equivalents would include checking, savings, investment accounts and anything else that you can easily convert to cash. Short-term liabilities would include debt payments for the current year on any outstanding credit card balances, student loans, auto loans, mortgage payments, etc. Note: a house is NOT a liquid asset.

Financial planners tend to suggest aiming for a current ratio of between 1.0 and 2.0. Note that increasing your emergency fund ratio can also help raise your current ratio.

I will be the first to admit that it is hard to have a “good score” with this ratio when you are younger.  Having that amount in cash equivalents is difficult when paying off debts. As you get older and closer to retirement, your current ratio should be in the healthy range.

Debt ratios

Debt ratios are a set of financial ratios that act as indicators of how well you manage your debt.  A couple of the more common debt ratios are below. If these look familiar, it is because these are ratios mortgage lenders use when approving mortgages.

Debt-to-income ratio

This is the percentage of monthly income spent on debt payments. As before, the debt payments include child support, mortgage or rent payments, loan payments and minimum credit card payments.

Debt-to-income ratio = (monthly debt payments ) / (monthly gross income)

The ideal range for the debt-to-income ratio is  <= 36% according to mortgage lenders.

Front-end ratio

The front-end ratio is one that lets a mortgage lender know what portion of your income will go to making mortgage payments.

Front-end ratio = (monthly housing costs) / (monthly gross income)

Note that monthly housing costs include principle, interest, taxes, and insurance. You want this ratio to be <= 28%.

Example: Your monthly housing expenses come to $2000, your monthly pre-tax income is $8000 and your other monthly debt payments total $800. This means your front-end ratio is $2000/$8000 =  25% and your debt-to-income ratio is $2800/$8000 = 35%.

Savings ratio

Your savings ratio is the percentage of your income you are saving. Savings includes money you or your employer contribute to a retirement account, as well as other savings accounts.

Savings ratio = (annual savings) / (annual gross income)

Experts say to aim for at least 10%. Unless you are retired, the higher the number, the better. If you want to retire early, you might even try and aim for a 50% savings rate.

Related post: How to Calculate Your Net Worth (and Why You Want To)

These ratios are useful to see where you stand today, but they aren’t the be all and end all. Remember, if you are young or recovering from a huge setback, you likely won’t have numbers in the ideal target range. That is ok. Work on your savings and, over time, the numbers should improve.

Did you calculate your financial ratios? Did I scare you with the math?