I’m a big proponent of treating your finances like a business in many ways. To achieve true financial success, it’s essential to be just as diligent and intentional about your spending and saving.
Savvy business owners use key metrics that help them ensure that their business is running smoothly. In addition, these measurements can help to track their progress to specific goals. I can’t emphasize enough the power of having clear, quantifiable financial goals.
The following measurements are the absolute most essential to know and track regularly.
Your net worth is simple to calculate but may be difficult to face if you have a lot of debt. Just remember that everyone has to start somewhere and most people that attend college start out with a negative worth. It’s progress that matters here!
To calculate your net worth, simply add up your assets (everything you own) and subtract your liabilities (everything you owe).
NET WORTH = ASSETS – LIABILITIES
For a more detailed discussion of how to calculate net worth, including an extensive list of assets and liabilities to consider, check out the (free) mini-class PF102: Creating a Net Worth Statement.
Guidelines for how much you should be saving abound. A general rule of thumb is 10-20%, with most of the focus being on retirement. However, if you’re deviating from the standard plan of working until 65+ and then retiring, you’ll need to save significantly more. Calculating your savings rate will help challenge you to increase your savings.
There seem to be a million and a half ways to calculate your savings rate. Of course, some methods are more accurate than others. Early Retirement Now has a great summary of different methods, examples and how to (and not to) calculate your savings rate.
There are two accurate ways to compute your savings rate. They both start by adding up all of your saving contributions:
- 401k and IRA contributions
- 401k matching (this is optional to include in the formula, but I recommend it as long as you’re vested in the employer plan)
- HSA contributions (the portion that you are investing for the future and not spending on medical expenses)
- Brokerage account contributions
- College savings plan contributions
- Mortgage principal payments (and you may also include other debt principal payments as long as they create equity in an underlying asset)
- Other savings (such as for an emergency fund, etc.)
Then, you can use either gross income or pre-tax income as the denominator to find the savings rate. Gross income should be used if you are looking for an absolute savings rate that reflects your overall current financial situation. Pre-tax income should be used if you are looking to determine how long it will take you to reach financial independence under the simple math behind early retirement, since you will likely no longer need to factor in the same high tax rate to your expenses.
SAVINGS RATE = (SAVING CONTRIBUTIONS + PRINCIPAL PAYMENTS) / GROSS OR PRE-TAX INCOME
Another name for the liquidity ratio is the emergency fund ratio. That’s exactly what we’re trying to get at here: if you had a major emergency and couldn’t work, how long would your current cash savings last you?
To calculate the liquidity ratio, add up all of your cash and cash equivalents (CD’s, money market accounts, T-bills) and divide the number by your monthly committed expenses. Your monthly expenses should include a basic budget that you would (and honestly could) follow during the time of an emergency. For example, you may reduce some of your discretionary spending on entertainment and eating out but you likely will still need some clothing.
LIQUIDITY RATIO = (CASH + CASH EQUIVALENTS) / MONTHLY EXPENSES
This ideally should be equal to 3-6 months or more. While a higher number signifies more financial stability, there is no need for most people to have more than 6-12 months of expenses in cash. It may be time to get started investing some of that cash if you’re in that situation.
Hopefully, you have a pretty good idea of how much of a return you are receiving from your investments. It may be possible that you are taking on too much risk for the amount of return you’re getting. Alternately, it may be that you’re paying significant fees that are eroding your returns. The only way to really tell is to calculate your own personal investment returns.
To calculate investment returns, the simplest method is to use Compound Annual Growth Return (CAGR). I’ve discussed how to calculate investment returns previously, so here I’m using an overly simplified example. The key here is to do the calculation for yourself and then compare it to a market index such as the S&P 500.
COMPOUND ANNUAL GROWTH RATE = (ENDING BALANCE – DEPOSITS + WITHDRAWALS) / BEGINNING BALANCE
There are multiple debt ratios that will be helpful if you are currently trying to reduce a significant amount of debt or applying for new debt such as a mortgage loan. The broadest ratio is the debt-to-income ratio. You can also use variations of this ratio, such as calculating monthly housing debt to income if your goal is to obtain a mortgage.
To calculate the debt-to-income ratio, simply add up all of your recurring monthly debt payments and divide it by your monthly gross income.
DEBT-TO-INCOME RATIO = MONTHLY DEBT PAYMENTS / MONTHLY GROSS INCOME
The lower the debt-to-income ratio the better, but there are some guidelines as well out there for a “healthy” amount of debt. Total debt should be limited to 36% absolute maximum to qualify for a decent mortgage, but the lower this number the better. I’m personally seeking a debt-to-income ratio of 0%.
BONUS: YOUR CREDIT SCORE
There is one more important measurement those that have encountered difficulty handling debt in the past or have had unfortunate employment or other circumstances that have caused them to go into significant debt or foreclosure. That measurement is, of course, their credit score.
Your credit score is used for a lot more than just being able to take on more debt (such as for insurance policy rates), so it’s important to track your credit score. You can learn more about credit scores here.
Don’t forget that the ultimate goal in calculating each of these measurements isn’t to determine whether it’s “good” or “bad” but to help you track your progress in your financial journey.
What metrics to you personally track in your finances?