3-Step Financial Checkup

So where do you stand financially? Are you on track to meet your goals? Given your age and income, have you saved and invested as much as you should have? How much house can you afford?

These were some of the questions I began asking myself several years ago. The problem is, it was difficult to find easy answers to these questions. So what that I have X dollars saved for retirement or for an emergency fund. Is it enough given my specific financial circumstances?

As a simple example, assume two families have $10,000 saved in an emergency fund. Is it enough? Of course this depends on the specific circumstances of each family, including what their monthly expenses are, how much debt they have, and how much they have saved in other investments. So to answer some of these questions, I devised a 3-step financial checkup. My goal was to keep it simple while also providing some meaningful information to help me assess my financial health. This post describes this 3-step checkup.

Here are the 3 steps:

  1. Prepare a Balance Sheet
  2. Prepare a Income Statement
  3. Analyze the financial data using several simple ratios and rules of thumb

Step 1: Prepare a Balance Sheet

A balance sheet is nothing more than a list of what you own (assets) and what you owe (liabilities). If the value of all assets is greater than all liabilities, the different is your net worth. If not, the difference is a net loss or deficit. I prepare a modified balance sheet, meaning that I exclude all assets that typically depreciate in value over the long run. This would include cars, boats, furniture, clothing, jewelry and so on. A typical modified balance sheet would have the following accounts:

  • Assets
    • Cash
    • Retirement Accounts
    • Non-Retirement Accounts
    • Primary Residence
    • Real Estate Investments
    • 529 Plans
  • Liabilities
    • School Loans
    • Mortgage debt (primary residence)
    • Mortgage debt (real estate investments)
    • Credit card debt
    • Car loan

One note on the liabilities. If a home equity line of credit is used in part to purchase a home, I include that in the mortgage debt. If some or all of the home equity line is used for other purposes, include it in other non-mortgage debt. In my case, I split the outstanding balance between these two accounts.

Step 2: Prepare a Income Statement

An income statement shows your income and expenses for a given period of time. In a typical income statement, expenses are allocated to a number of different accounts to give some idea of where the money was spent. If income exceeds expenses, the difference is your net income; if not, your net loss. In my modified income statement, however, I use only four expense categories. Here’s what it looks like:

  • Income
    • Salary
    • Other sources of income
  • Expenses
    • Taxes
    • Mortgage (primary residence)
    • Debt repayment (credit cards, school loans, car loans, etc.)
    • Other Expenses

Note that I don’t use a category for savings. The reason is simple. If income is greater than expenses, the resulting net income is the amount saved, whether the money is placed in a 401(k), IRA, savings account or even left in the checking account.

Step 3: Using Ratios and Rules of Thumb

With the balance sheet and income statement complete, we can now run the numbers through several ratios and formulas to see where we stand. There are many ways to analyze the numbers, but here are the ones I use the most:

    • Emergency Fund Ratio (Liquid Assets/Monthly Expenses):

This ratio determines how many months worth of expenses can be funded through liquid assets. Liquid assets are all assets that can be converted to cash in a matter of days without significant penalty. Liquid assets include primarily cash, although you can include taxable investment accounts if you factor in the taxes you would owe when you sold the investments. The generally accepted rule of thumb is that you need 3 to 6 months of expenses in an emergency fund. To put this in perspective, if you save 10% of your gross income, it will take about 7 months to save one month worth of non-tax expenses.

Example: $10,000 (cash) / $4,500 (monthly non-tax expenses) = 2.2 months

    • Doomsday Fund Ratio (Financial Assets/Monthly Expenses):

The Doomsday Fund is what I call the situation where the financial wheels of your life have come off in a big way. Everyone in the family has lost their jobs and you can’t find work–how long could you last without moving? Unlike liquid assets, financial assets include retirement accounts and other accounts that would levy a penalty for liquidating the account (ex, a 529 Account, certificates of deposit). Of course, you have to deduct the penalties and taxes from your account balances before including the numbers in the formula. The Doomsday Fund Ratio is actually helpful in retirement planning, but more on that at another time.

Example: $150,000 (financial assets) / $4,500 (monthly non-tax expenses) = 33.3 months.

    • Mortgage Payment Ratio (Monthly mortgage payment/monthly income):

The mortgage payment ratio shows how much of your gross monthly income goes to your mortgage payment, including taxes and insurance. As a rule of thumb, anything more than 28% can get uncomfortably high. My preference is for this number not to exceed 20%. Of course, the interest rate you are paying on the loan makes a big difference with this formula, so be sure to check out the best mortgage rates if you think you may be able to refinance.

Example: $2,000 (mortgage payment) / $8,800 (monthly gross income) = 22.7%.

    • Mortgage Debt Ratio (Mortgage balance/Yearly Income):

This ratio compares your mortgage debt to your annual income. A good rule of thumb is that mortgage debt should not exceed 2.5 to 3 times your annual income. In some areas of the country, however, this is a very difficult limit to meet. And some mortgage companies today approve loans that significantly exceed this amount. Also, as you near retirement, this number should go down as your mortgage balance decreases (hopefully).

Example: $300,000 (mortgage debt) / $95,000 (yearly income) = 3.1

    • Total Debt Ratio (Total Debt / Net Worth):

This ratio compares total debt (including mortgage) to net worth. As a rule of thumb, this ratio should be below 1. Of course, if you’re just out of college and have school loans, the number can significantly exceed one.

Example: $300,000 (total debt) / $400,000 (Net Worth) = .75

    • Total Debt Payment Ratio (Monthly Debt Payments / Monthly Gross Income):

This ratio compares your monthly debt payments (including mortgage) to your monthly income. As a rule of thumb, anything greater than 38% can get uncomfortable. My goal is to keep this ratio below 25%.

Example: $3,000 (monthly debt payments) / $10,000 (monthly gross income) = .30 or 30%

    • Liquidity Ratio (Liquid Assets / Non-Mortgage Debt):

This ratio helps determine your ability to cover your non-mortgage debts. My goal is to have liquid assets equal to or greater than my non-mortgage debt. In other words, this ratio should be at least 1.

Example: $50,000 (liquid assets) / $40,000 (non-mortgage debt) = 1.25

    • Net Worth Ratio (Net Worth / (yearly income * age / 10)):

This ratio looks more complicated than it really is. The idea is to evaluate your net worth in light of your age and income. Two individuals may both have a net worth of $500,000, but that number alone doesn’t tell you where they stand. If one is a 35 year old school teacher making $45,000 a year, and the other is a 62 year old engineer making $125,000 a year, their respective net worth will look very different. As a rule of thumb, you want this ratio to be 1 or higher, which is achievable if you regularly save at least 10% of your gross income.

Example: $300,000 (net worth) / ($100,000 (yearly income) * 35 (age) / 10) = $300,000 / $350,000 = .86

    • Retirement Fund Ratio (Retirement Savings / Yearly Income):

This compares your retirement savings to your yearly income. Like the Net Worth Ratio, it gives some meaning to how much you’ve saved for retirement, rather than just looking at an account balance. According to an article written by Charles Farrell and published in the Journal of Financial Planning, the goal is to retire with at least 12 times your annual income. I think this number will vary significantly based on individual circumstances. My personal goal is 15 times annual income. As for where you should be at a given age according to Mr. Farrell, see the savings to income column in the chart to the right.

Example: $350,000 (retirement savings) / $95,000 (yearly income) = 3.7

There are other ratios and formulas you can apply to personal finance. But the ones above should give you a clear picture of your financial health and help to identify those areas of your finances that are on track and those areas that need improvement.

2 Responses to “3-Step Financial Checkup”

  1. For Total Debt Ratio, my debt is $7500 (student loans) and my net worth is -$7500, thus my ratio is -1. According to your guidelines, this is below 1 and thus is a good ratio.

    You may with to reconsider.

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