No matter your current financial state, there are huge benefits to be had from tracking meaningful financial ratios.
Besides your net worth, try tracking the following three ratios. I guarantee you will see large improvement in your finances.
Net Wealth = (Net Worth) / (average monthly expenses/30)
No other financial ratio gives you a better description of your current financial state, than your net wealth.
What I like about calculating your net wealth, is that it gives meaning to your net worth.
For example, Sam Spender has a net worth (asset – liabilities) of $1,000,000. Sam spends $1,000 a month on average a day. Therefore, his net wealth would be 1,000. Meaning, if Sam maintained the same lifestyle and had no income, he would run out of money in 1,000 days.
Next, we have Frank Frugal. Frank has a net worth of $500,000. Frank spends on average $3,000 a month or $100 a day. With his current spending habits, Frank can maintain the same lifestyle for 5,000 days without any income.
If you just looked at their net worth, one would assume that Sam’s financial situation is twice as good as Frank’s. However, by looking at their net wealth, you see that Frank is five times “wealthier” than Sam.
Net Savings = Money Saved / Money In
I started tracking my net savings, when I first heard that John Templeton’s rule was to invest $1 for every $1 he spend. He eventually went on to becoming a billionaire, so I think it worked.
While I’m far from achieving this $1:1 ratio, I do plan on getting there. Every year, my goal is to increase my savings rate from the previous year.
What I also like about tracking my net savings is that it takes away the guilt I usually put on myself for spending. As long my net savings has increased from the previous year, I can buy whatever I like.
Emergency Fund = Cash / Monthly Fixed Expenses
The last meaningful financial ratio that I track, is my emergency fund.
Why do I find it important to track my emergency fund? There are two reasons.
First, it’s comfortable knowing that if something happened, I could live off of just cash for a certain period of time. In other words, I sleep better at night.
Second, I don’t like having cash sitting around without a purpose. For example, say my optimal emergency fund is $10,000. If I have more than $10,000 in my bank account, that’s money I should put towards goals.
How Often Should You Calculate?
When I first begin tracking my finances, I computed the above equations, plus my net worth, twice a month. The reason, I wanted to update my net worth each time I was paid.
After doing this for a few months, I moved on to tracking my finances once a month.
I then tried to track once every three months. However, I found that three months was too long.
By calculating once a month, I could easily estimate what my progress had been. When I switched to three months, I felt like a lost some control. I had no clue how I was doing because so much changes inside of 90 days.
Calculating these ratios and my net worth once a month, has worked well. At all times, I feel like I know where exactly where I stand.
Test different lengths of time for yourself. If you feel like you can go an entire year and still have an accurate snapshot of where you currently stand, that’s great. There is no right or wrong answer. The goal is to know where you’re and where you’re going, at all times.
What about Benchmarks?
There are so many variables when you’re younger, that it’s pointless to try to benchmark each financial ratio.
I was lucky enough to graduate college without any debt. Plus, I lived at with my parents, while working full time for two years. I also had another job coaching basketball. By the time I moved out, I was contributing to my 401(k), maxing out my Roth IRA, saved for an engagement ring and wedding, and had enough for a down payment on a house.
In contrast, some of my friends are just getting out of grad school right now at 26 years of age, with a good chunk of debt to payoff.
Instead of comparing our situations, it’s better just to track your own improvement. Don’t worry about where others are at. Each month your goal should be to do better than you did the previous month. Not to compare yourself to others.
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In the comments, let me know what else you find helpful to track.
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Photo by: Patrick Hoesly
{ 12 comments… read them below or add one }
Great post, I think I may start tracking my Emergency Fund. Thanks for your great post!
Absolutely true. Tracking the little stuff keeps you from making the big mistakes. Attention to the details is always the best way to really know whether you are making the right moves or just think you are.
Pat
http://compoundingreturns.blogspot.com
I’ve seen benchmarks that say my net worth should be X amount based on my age but I wonder if they take into account student loans? ‘Cause I am drowning in them.
Rj – interesting you should talk about reserves and a good level being $10,000. Keeping in mind that you are familiar with a commission based job, do you feel like $10,000 is enough? Are you targeting a six month reserve or twelve month reserve?
Lets say I have well over a year in reserves, do you think I should take some of that cash and do the following:
- pay off my student loan
- max out my roth 401k
Interested to hear your take.
I really like these ratios. I’m definitely going to start tracking my net savings. I think that net wealth ratio can be a bit misleading though. For example, what if a large chunk of your net worth is made up of your home, which you have paid off early?
In your example what if Franks net worth of $500,000 was made up entirely of his home. In that case he would need to sell it if he wanted to live off his net worth. He would then need to rent an equivalent place to maintain the same lifestyle. Lets say that adds $3000 to his monthly income. Suddenly his net wealth has dropped to 2,500 days.
This is an extreme example, but it shows the make up of your net worth can have an effect on your cost of living which in turn affects the number of days you could live off it.
@Michael Evans – This is why it’s highly debatable to include your home in your net worth, in the first place. Personally, I don’t. As a homeowner, it makes me feel “richer” than I really am, a term in economics known as “The Wealth Effect.”
@Sad Bears Fan – I just made up that $10,000 figure. Personally, I have over a years worth of expenses because my wife and I are both starting new and uncertain careers, which equates to more than $10,000. If you have a stable job and no kids, a year is probably too high. In that case, I would max out your Roth 401(k) or pay off student loans.
Rj, True, although it can also be inspiring to see that high net worth when you’re trying to pay it off early. I have two net worth totals in my spreadsheet, with and without my house. Maybe I should track the ratio between those two totals
I think I want to see progress right away, I’ll probably calculate weekly for the first 3 months, then biweekly, then monthly. Great tips. Looking forward to seeing my progress.
I like this idea because sometimes just having a number called net worth doesn’t really tell the whole story.
I was going over my dad’s lawn mowing business to show him the basics of assets = liabilities + owners’ equity and it was amazing to see how all the details worked out when I presented the final findings to him with charts and ratios.
I haven’t gone back in and checked but do you include your cars in net worth? For example, if you have a car that you paid $20,000, it has a balance of $13,000 and Kelly Blue Book value of $14,000 do you claim the $1,000 difference as your value?
My rule of thumb, which doesn’t necessarily make sense for a business, is to not include anything that I can’t and don’t want to live without. To me including something like my wedding ring or car, two items that I don’t want to sell and don’t plan to sell, would just inflate my net worth.
Have you thought of multiplying the monthly expenses by 12 instead of dividing by 30, so that the net wealth will be measured i years? I find it hard to visualize how long 5000 days actually is, but 13.8 years immediately makes sense.
Michael – Not until now but that makes sense. Thanks for the suggestion.