June 21, 2012

Pop Quiz!

Credit: FreeDigitalPhotos.net
One of the many ways financial analysts and investors value the financial strength of a potential investment is by looking at ratios. Auditors frequently look at ratios when trying to determine the overall financial condition of companies or organizations. I consider ratios when I’m playing poker or trying to make a late-round fantasy sports draft pick.

Today, I thought we’d do something a little bit different. I thought I’d give you some homework. I’m going to share with you three, simple math problems that will generate ratios. If you actually take the time to calculate your own, personal ratios, I can almost promise you will be able to gain some valuable insight about your financial situation.
  1. The Current Ratio: Current Assets / Current Liabilities
    • a. Add up how much cash you have in your bank accounts and CDs.
    • b. Add up what bills, credit card balances, and other debt you will have to pay within the next 30 days.
    • c. Divide a. by b., and see what you get. A ratio greater than 1 means you have enough readily available assets to pay off your short-term expenses. A ratio less than 1 means you could be in some financial trouble really soon. Strive for a ratio between 3 and 6.
  2. The Savings Ratio: Savings Per Year / Annual Gross Income
    • a. How much money did you save last year?
    • b. What was your gross income (salary, pension, Social Security, investment income, etc.) last year? (Get your tax return if you need to!)
    • c. Divide a. by b., and let’s see how you’re doing. Consider that your savings strategy should be based on your financial goals and stage in life. A ratio of .1 or better is admirable in my book. If your ratio is below .1, see what you can do to raise it. If your ratio is negative (you didn’t save anything), start saving now!
  3. The Housing Cost Ratio: All Monthly Fixed Housing Expenses / Monthly Gross Income
    • a. Add up your monthly rent/mortgage payment, monthly homeowners association fees, and monthly homeowners insurance costs.
    • b. Take your annual gross income from number 2b., and divide by 12.
    • c. Divide a. by b., and take a look. Lenders generally want to see a ratio less than .28. If your ratio is above .28, your potential lender may feel uncomfortable, and that in turn should make you feel uncomfortable. You can also use this ratio if you are considering renting or buying a new place and you’re trying to figure out what you can realistically afford.
If you didn’t like your results, don’t be discouraged. There's always room for improvement - trust me. Keep in mind that these ratios are not hard and fast laws, but they can be good indicators as to the quality and strength of your financial situation. If you did like your results, do as my granddad used to say, and “Keep on keeping on.”

Ratios are not mathematically difficult and can provide some profound data. If you take the time to figure these financial ratios periodically, you will actually be doing some very basic financial planning yourself. Well done!


No comments:

Post a Comment