How do you currently try to understand your finances?
Your mind might be racing with tons of information on how you’re on top of balancing your budgets, spending, and investments. Fantastic – at least you’re thinking about these things, that’s better than a lot of people! If you haven’t given it much thought – probably because it makes you depressed when you do – don’t worry, you’re in really good company and I can totally empathize.
Let me tell a quick story from my side that more than a few of you can probably relate to and then I’ll share some learnings that most everyone will find really valuable. Just bear with me for a second.
Why this is important to me
If we rewind a couple years ago, I was living a good life. I was in my late twenties and was climbing the corporate ladder quick – aka making great money. I thought I was pretty smart with my finances too. I used Mint to track my expenses, I was investing into stocks, and paying substantially into my company’s retirement fund.
Problem was that it all turned out to be an illusion of security. And Miss Reality is actually an expert MMA fighter that does NOT pull any punches. All metaphors aside, I lost my job due to a huge industry recession and found out real quick just how risky my personal finances had become.
Apparently having a higher income, saving for retirement, and comprehensive insurance coverages did NOT protect me the way I needed it to. I was nowhere near as safe as I had thought.
So, how could I have prepared better when I didn’t even know I was at risk?
A brief thought exercise:
Imagine Jane and Tom. They both have $7,000 in their savings account. Would you say they’re doing well? I bet if we asked 10 random young adults off the street, they’d say “sure!”.
What if you had more information – such as Jane lives modestly with roommates in a rental house. Her monthly budget is about $1,400 for everything. Meanwhile, Tom lives big and spends on average $4,800 per month (apartment, luxury car, credit card debts, loan payments, and high food and social costs).
Has your perception changed on how they’re doing? Who’s in a riskier position and why?
What if I instead of telling you how much they each have in their savings accounts, I told you that Jane and Tom have cash ratios of 5 and 1.5 respectively? Assuming you knew what these numbers represented – I’ll explain later in this article – you immediately have a clearer picture of who’s at risk and how much.
Back to the main point:
This is the power of ratios. They take multiple factors – i.e. savings AND spending habits – and tie them together so you get a more well-rounded understanding of how you’re doing.
After years of reading, calculating, and discussing this topic, we believe it all starts with monitoring 3 key ratios. Some of these are textbook, while others have been heavily modified – and even renamed – to make them more relevant to normal people like us.
If you think reading this post will make you sound smart please stop now. To learn the technical everything about financial ratios, google “personal finance ratios” and happy reading!
My purpose here is to teach you how you can start routinely measuring your finances in a more meaningful way. If you do this on a monthly basis and take tiny steps to improving each month, your money situation WILL improve.
So, without further delay, let’s get to it. In order of priority…
#1 Lifestyle Surplus (heavily modified Savings ratio)
What does this represent? Simply put, it’s a measure of how much excess money you have coming in after you subtract out your average monthly spending to keep the lifestyle you’ve chosen for yourself. This one is by far the most important in determining our total Financial Stability Index (FSI). Because a low rating means we’re living outside of our means and need to take immediate action to course correct.
How to calculate:
Take Home Pay: This is the amount that is deposited into your bank account. So (+ Monthly Income), (- Taxes). Example: (+$2500 income) (-$625 taxes) = $1875 take home pay
Monthly Cost of Lifestyle: (+Rent) (+vehicle costs) (+utilities) (+food) (+entertainment) (+medical costs) (+ insurance) (+gifts) (+misc expenses) (+subscription services) (+MINIMUM debt payments)
Basically if you’re looking at Mint, include everything in your monthly spending except take out any money moved into investments / savings and any “extra” payments made into paying down debt or financing.
Lifestyle Surplus = (Take home pay – Cost of Lifestyle) / Take home pay x 100
Healthy target: +10%
What if I’m below 10%?
You already know the answer to this question. You need to adjust your lifestyle. Be ruthless, be merciless. Nothing is a “must-have”. There’s people living on minimum wage and making it work. Move in with parents, co-habitate, eat out less, drink water out of the tap, quit netflix… whatever you have to do get this over 10% otherwise you will NEVER be safe.
What if I’m over 10%?
Great work! Stay diligent here, and if you MUST dip your number below 10%, understand you’re putting yourself in a risky situation. Now you can start looking at the next core aspect of your personal finances.
#2 Cash Ratio (slightly modified)
The standard cash ratio uses your actual liabilities, aka the stuff you HAVE to pay each month. But that’s crap, because this is the real world, and according to human nature we’ve convinced ourselves that stuff we’re spending money on IS a must have. It’s very, very difficult to cut things from our monthly budgets – as you probably understand from #1.
So, for the sake of being super conservative, and helping you keep a continuous lifestyle despite whatever happens, let’s just plan using the same number you used above in #1.
How to calculate:
Total Savings: (+savings balance) (+conservative stock estimates)
Cost of Lifestyle: See #1
Cash Ratio = Total Savings – Cost of Lifestyle
(resulting value = # of months you can cover your lifestyle without income)
Healthy target: 3 months
What if I’m below 3 months?
FOCUS on building your immediate nest egg. Stop investing in your long-term stuff until you have this shored up to at least 3 months. Do NOT use this money for things like trips or down payments. This is your body armor, or maybe more literally your life armor. Always keep your armor on, you never know when you’ll need it.
What if I’m over 3 months?
That’s awesome. Now you can start investing in your long-term financial stability goals such as retirement, children’s tuition funds, stocks, etc. You can also save up for “life experience investments” which are equally important. Otherwise, what’s the point? This is all assuming that you’re living in a healthy range for your Lifestyle Surplus… if that’s not the case, stop and go back to #1.
#3 Solvency (textbook – unmodified)
Ok, I’m sorry, I tried to shelter you from financial jargon, but I promise this one’s really not as scary as it sounds. What we want to understand here is “If I lose everything, will I be able to pay my debts or will I be declaring bankruptcy”?
How to calculate:
Net Worth = (Total Assets) (-Total Liabilities)
Total Assets = (+home equity) (+vehicle equity) (+cash) (+savings/checking) (+stocks) (+0.65 x retirement balance) (+any other assets you could reasonably convert to cash)
Total Liabilities = (+loan balance on home) (+loan balance on car) (+credit card debts) (+loan balances) (+any other outstanding monies owed)
Solvency = Net Worth / Total Assets = (Total Assets – Total Liabilities) / Total Assets
Healthy Target: 0.5
What if I’m below 0.5?
Assuming you have #1 and #2 in healthy order, then you’ll want to FOCUS on paying down your liabilities as fast as possible. Take the one with the highest interest rate – that’ll give you the biggest bang for your buck. Do this until you get around 0.5.
What if I’m above 0.5?
Assuming you have #1 and #2 in good position, then my friend, you can sleep easy! You’re probably going to be ok and should be able to weather most any shit-storm life throws at you in the near future. Keep working on building wealth by investing cash into interest-bearing accounts.
Calculate, document, and focus on improving in small increments until you feel safer. It’s not easy, but trust me – it’s well worth it! Do it now while it’s a choice.
This will only help you become financially stable for the short term. The next step is to look waaay down the road to your retirement. I have a method for this too, however, it’ll take a bit more discussion and as such I’ll talk about it in our upcoming post.
What other financial ratios have you applied to your life and find most insightful? Post in the comments below and let’s talk about it – I read everything you say!
-Tyler Cobb | Co-Founder & Product Manager