Few of my clients may realize that the Federal Reserve Bank tracks year to year changes in household balance sheets. That is, our nation's top bank wants to know spending vs. savings patterns as these trends relate to national consumption.
What is interesting about this research is to learn that for many households, the cars parked on the family driveway may represent more value than the sum of family retirement accounts. Households are paying down more debt, but are still saving on average a measly three to four percent of annual earnings.
Anyone who has ever tried to finance a car, or buy a home, is familiar with credit scores. Issued by private companies, these scores are an aggregate measure of creditworthiness taking into account current household income, existing household debt, and repayment patterns for debt incurred.
As a financial planner, I go beyond credit scores to "grade" my client's finances using still other financial ratios. These may include measures of current liquidity of cash flow, and a balance sheet of current assets and liabilities. We identify any unfunded future liabilities as well as those that are already incurred.
Lenders may look at these additional ratios when they are shown in the form of a personal financial statement of cash flow and net worth. For instance, savings balances are a good indicator of the level of liquidity a household may have in the event of an emergency, such as the loss of a job.
"Banks certainly look at credit scores when qualifying borrowers, but they also consider and analyze income and outstanding credit ," said Stacie Strassberg, Senior Mortgage Advisor, First Cal Mortgage, San Rafael. "Other considerations are ratios for total 'Debt to Income'; for liquid assets; and for the 'Loan to Value' of the subject property."
However, the usefulness of these types of measures goes beyond simple lending considerations. Anyone wanting to build up financial security for retirement should go beyond the balance sheet a mortgage lender may want for decisions today.
Here are some of the simpler calculations you can do on your own, to take stock of where you and your family may be with regard to your financial goals. If you are sorting through the tax records for the 2013 filing, it's a good time to analyze the data at hand.
Cash Flow - A measure of household liquidity and ability to sustain itself in emergencies
Sum current income, from salaries, dividends and interest payments, and divide by payments on accounts, whether these may be mortgage payments, or those for credit cards or taxes.
A positive balance indicates money available for working capital and savings. Ideally, this figure should represent about 20 percent of cash coming in, but varies somewhat depending on whether you are saving pre tax or post tax.
For your quick ratio, you would divide current assets by current liabilities, ignoring your home and mortgage. These are considered long term assets and liabilities. Other long term assets should also be ignored, such as business interests, when measuring your current liquidity. The quick ratio assesses how much cash you could raise in a short period of time when faced with an emergency.
Net Worth - What you are building toward
Use a personal finance template to create separate columns, one for all assets, including cash, marketable securities, business or equity in real estate interests. Separate the business ownership and family home and real estate into a separate block for long term assets. Although cars are part of net worth you may choose not to include them for this exercise. They are use assets rather than assets purchased as investments.
The other column would cover all liabilities, encompassing balances on all debts and taxes payable. Separate short term debt from long term debt. Long term debt for instance would be that incurred for a mortgage, payable over many years, not just one year. If you are making payments on your cars, include those. But be sure to count the cars as assets in this case.
When subtracting all liabilities from all assets, ideally you get a positive number.
Debt to income ratios - Controlling current outflows
If you are managing your debt well you should fall into these parameters.
Your payments to own your primary residence should be calculated by summing annual payments for principal, interest, taxes and insurance and dividing by gross household income. The percentage should not top 28%.
Your payments for all debt including that for your home should not top 36% of gross income.
Your payments to service consumer debt should not top 20% of net income.
Savings rates - What is your time horizon?
For people unsure of whether they are saving sufficient money toward goals, I suggest figuring the sum of money necessary by a specific date to fund a goal. If you assume no market return or inflation, then you would divide that sum of money by the number of years remaining until the date needed. The resulting figure would be the amount necessary as an annual savings to fund the goal.
In reality, there is inflation and most people do opt for some market return, to help lower the amount necessary to fund a longer term goal. To calculate the effect of inflation-adjusted return there is a formula you would use to adjust the needed savings rate. The amount is further adjusted with a present value analysis of the value of future dollars. There are online calculators that help you, however, achieve higher accuracy in these calculations than may be possible with a simple calculator approach.
In my financial planning, I use sophisticated software algorithms to predict ranges of outcomes over longer periods, so my clients know how much to save. They also know what to safely expect for their savings programs.