Article 119 Financial Tune-Up - Part 2 on Personal Financial Ratios
Financial tune-up part 2 is here but let us review what we just covered in Part 1 which is on finding where we are, that is the current situation. To find out where we are, we found the net worth by adding all the assets and liabilities. Then we deducted the total liabilities from the total assets and we found our net worth. You probably found you were richer than you thought.
Part of determining where we are is crunching a few numbers or ratios as these numbers will describe further what we have to do next. They will give us a good picture of our financial health and whether to implement changes to make the picture even better. It is wise to find out if we are on target for each of the ratios. The targets will of course depend on where we are in life.
Why do we have to measure our finances? It is the only way we can be sure if we are on target and headed in the right direction. We do not measure where we are to compare with others because if their net worth is on the stratosphere we may just be discouraged and stop our effort to gain financial independence.
Neither should we measure our results with others who are in worse position than we are because this could make us feel so smug that we will slack off and make financial errors. No, what we need is to measure our situation against benchmarks that have worked well and compare the results with the last ratios we found.
Using these ratios can make us live more effectively with our money. It is not really how much money we have, it is how we manage the money that makes us personally comfortable to the point we make the money work hard for us rather than the other way around. These ratios can help us analyze our own financial standing based on the benchmark formulated by Farrell.
Ratios are used by investors to measure the stock they want to purchase as to their price-to-sales and price to earnings ratios in order to gauge the values of the companies that are publicly traded. In the same vein, we can measure the relationship between our incomes, debt levels and savings.
Debt to Income Ratio
Before we go into Farrell table of financial ratios, let us look at this debt to income ratio first as an example. The target here or the goal is to use no more than 30% of ones gross annual income for paying the debt. The younger ones should not use more than 30% of their gross annual income to make payment to all their debts including mortgage, car loans, student loans and revolving debts. This percentage should go down to zero when ready to retire.
Say we earn a gross income of $50,000 a year. The formula for obtaining how much is the total payment we pay compared to our annual income is this: Annual Debt Payment / (or divided by) Annual Gross Income multiplied by 100 = (equals) the percentage of our total annual debt payment.
Let us follow that formula by obtaining the total amount of debt payment we have for the year. Say our total mortgage payment is $12,000 + total car payment of $2,400 + annual student loan payment of $1,2000 + annual revolving debt payment of $600 = $16,200 which is the total amount we pay for payment of debt . Following the formula, we divide $16,200 by our annual gross income of $50,000 and then multiply the result by 100 and we get 32.4% of the total annual debt payment.
Those who are under 30 years old should not really use more than 30% to pay for their debts so we have to be careful in buying anything on credit and try to lower the debt amount or raise the income we get each month. Later on, I will let you know how to find some hidden money that will effectively lower the percentage of debt payment so we can be on track.
That’s only an example on how a financial ratio will help get us on track. I probably should show you how to find some hidden money before we go to the next financial ratio. That way we will feel more confident on going through the financial tune-up.
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