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Analyzing Your Financial Statements With Ratios

By JLP | October 11, 2006

Now that we have a couple of model financial statements to look at, it is time to use ratios to analyze those statements. You may want to print out the posts with the model statements so that you can look at them while studying the ratios.

Here are links to the two posts that contain the financial statements that we will use for to calculate the ratios:

Net Worth Statement

Cash Flow Statement

Let’s get started…

Liquidity Ratios

When an asset is “liquid” it means it can be turned into cash quickly. Cash is the most liquid asset. Real estate, on the other hand, is illiquid.

1. Basic Liquidity Ratio (BLR)

BLR = liquid monetary assets &#247 average monthly expenses

From the Net Worth Statement, the liquid monetary assets would be:

From the Cash Flow Statement, the average montly expenses would be the sum of the fixed and variable expenses:

The sum of the fixed and variable expenses is $62,200.

Here’s what the BLR would look like:

BLR = $16,200 &#247 ($62,200 &#247 12)

BLR = $16,200 &#247 $5,183

BLR = 3.1 months

This ratio tells us that this couple could live on their liquid assets for 3.1 months based on the average monthly expenses and their liquid assets. Since it is common knowledge that a person should have 3 to 6 months worth of living expenses in liquid assets, the ratio of 3.1 months is on the lower end of acceptability.

Debt Ratios

1. Debt-to-Assets Ratio

Debt-to-assets ratio = total debt &#247 total assets

Looking on the net worth statement, we see that the total debt (total liabilities) is $225,000 and the total assets are $618,300. Therefore, the math looks like this:

Debt-to-assets ratio = $225,000 &#247 $618,300

Debt-to-assets ratio = .3639 or 36.4%

This number shows us that this couple owes a little over 36 cents for each dollar in assets. This couples’ goal should be to substantially reduce this number as they near retirement. If they were able to pay off their student loans, their ratio would improve to 31.5%.

2. Debt-to-Gross-Income Ratio

Debt-to-gross-income ratio = annual debt repayments &#247 annual gross income

From the cash flow statement, we see that this couple has mortgage payments of $8,000 per year and loan payments of $4,000 per year for a total of $12,000. Their annual income is $107,000. The math looks like this:

Debt-to-gross-income ratio = $12,000 &#247 $107,000

Debt-to-gross-income ratio = .1121 or 11.2%

Anything under .30 or 30% is considered enough income to meet debt repayments. At 11.2%, this couple’s debt-to-gross-income ratio is acceptable.

3. Debt Service Ratio

Debt service ratio = annual debt repayments &#247 annual net income

For this calculation we use the same $12,000 of annual debt repayments as above and net income after all deductions ($107,000 – $44,580 = $62,420).

Debt-to-gross-income ratio = $12,000 &#247 $62,420

Debt-to-gross-income ratio = .1922 or 19.2%

For this ratio, anything under 40% is considered adequate. A ratio of .1922 is well within the adequate range.

Savings Rate Ratios

The only way to build financial security is to save and invest income rather than use it for current consumption. Savings rate ratios tell us how much much is being saved and invested.

1. Investment-Assets-to-Net-Worth Ratio (IANW Ratio)

Investment-Assets-to-Net-Worth Ratio = investment assets &#247 net worth

We find this information on the net worth statement. Looking at the net worth statement, we see that the total investments are $335,000 and the net worth is $393,000. Plugging these numbers into the formula we get the following:

Investment-Assets-to-Net-Worth Ratio = $335,000 &#247 $393,000

Investment-Assets-to-Net-Worth Ratio = .8524 or 85.24%

This ratio tells us that this couple’s investment assets make up over 85% of their net worth. This is a very good percentage. The closer you get to retirement, the higher this number should be. It is important to remember NOT to include investments that may be set aside to meet a certain goal (like a college education or new car or something like that). The more conservative and truthful you are in valuing your assets, the better.

2. Savings-to-Income Ratio

How much of your income are you allocating to savings? This ratio will help you gauge that.

Savings-to-income Ratio = amount saved &#247 annual income

This information is located on the cash flow statement. We can see that this couple puts $12,000 per year in their 401(K) and another $6,000 per year away in investment plans. We will assume that the $4,500 going into education is funding education expenses and is not considered “savings.” The annual income for this couple is $107,000, for the following equation:

Savings-to-income Ratio = ($12,000 + $6,000) &#247 $107,000

Savings-to-income Ratio = $18,000 &#247 $107,000

Savings-to-income Ratio = .1682 or 16.82%

This couple is currently saving nearly 17% of their income. This is a good amount to be saving, especially when you consider the fact that they are paying off their mortgage and student loans. Once these two obligations are taken care of, this couple should be able to save an even higher percentage.

Real Growth Ratios

“Real Growth” is growth adjusted for inflation. When people talk about real returns on investments, they are talking about the investment’s return minus the inflation rate.

1. Growth of Income Ratio

Did your income keep pace with inflation? This ratio will tell you:

Growth of income ratio = [(income this year - income last year) &#247 income last year] – inflation rate

Since this is a hypothetical example, we’ll have to make a couple of assumptions. First, we’ll say that last year’s income was $103,000 and that the inflation rate was 3.5% (.035 as a decimal). We saw from above that this year’s income was $107,000.

Growth of income ratio = [($107,000 - $103,000) &#247 $103,000] – .035

Growth of income ratio = [$4,000 &#247 $103,000] – .035

Growth of income ratio = .0388 – .035

Growth of income ratio = .0038 or .38%

This couple’s growth in income narrowly beats the inflation rate.

2. Growth of Net Worth Ratio

Is the growth in your net worth keeping pace (hopefully BEATING) inflation?

Growth of net worth ratio = [(net worth this year - net worth last year) &#247 net worth last year] – inflation rate

Once again, we will have to make a couple of assumptions. We will assume that last year’s net worth was $340,000 and that the inflation rate was again 3.5%.

Growth of net worth ratio = [($393,000 - $340,000) &#247 $340,000] – .035

Growth of net worth ratio = [$53,000 &#247 $340,000] – .035

Growth of net worth ratio = .1559 – .035

Growth of net worth ratio = .1209 or 12.1%

This couple’s net worth had a real growth rate of 12.1% last year. This is a very good growth rate. Maybe this couple is taking on too much risk? We can’t know that without further analysis.

So, there you have it! That’s it for the ratio analysis of financial statements. Where do we go from here? You’ll have to check back and see!

Topics: Basics, Financial Math Basics, Financial Planning | No Comments »