When I was about six years old, I really wanted to fly. If there had been a school for flying, I would have been the first kid on the bus. So you can imagine my delight on that bright New England Saturday morning when, thanks to an episode of Superfriends, I finally learned what to do.
I went outside on our front lawn and I began to spin around. Then, with my arms out and the wind in my face, I said these words:
Oh Zephyr winds that blow on high, lift me now so I can fly!
Since spinning around while reciting that chant made flying possible for Ms. Andrea Thomas, high school science teacher by day, goddess-empowered Freedom Force heroine by night, surely it could work for me! So I spun, spun and spun! I spent the morning spinning, falling down, and spinning again. I spun, I chanted, and in the end, I lay on the couch with the worst headache of my young life. The only time my feet left the ground was when my Dad carried me into the house because I was too dizzy to walk.
While I didn’t get to fly that day, I did learn an important lesson, which, as it turns out, is just as important in building wealth as it is in flying:
What works for one person will not necessarily work for you!
Imitating behavior is a natural part of learning. From playing peek-a-boo, to improving our back-swing, doing what “they” do can be a great way to learn. But when it comes to building wealth, imitation can get us into big trouble. Why? Financially speaking, we are all unique. We have different income levels, sources of income, lifestyles, debt levels, goals, responsibilities, legal obligations, earning potentials, work-related benefits, tax burdens, insurance coverage, health considerations, risk tolerance levels, financial behaviors, on and on and on. Every household has its own set of financial characteristics that each member’s path to success his or her own. In fact, what works for one could be downright detrimental to another!
So if we shouldn’t do what “they” do, what do we do when we need a financial solution? We calculate! That’s right, in flying and in finance, it’s not copying, but calculating, that gives us the answers.
By using calculations that compare two specific numbers, called ratios, we get the chance to expose what we are doing right and what we are doing wrong in a particular situation.
For example, if you would like to fly but can’t get off the ground (and you happen to have wings) you can use flight ratios like Lift to Drag, Thrust to Weight, or the Aspect Ratio, to evaluate what’s going wrong. Similarly, if you are trying to build wealth but it’s just not working, turn to financial ratios for help.
Financial ratios offer a great way for all of us to efficiently evaluate our strengths, weaknesses, and financial progress. These ratios are easy to use, specific to our situation, and super powerful! You can find a financial ratio for almost any question, from “Do I have enough cash in my emergency fund” to “Is the rental price I’m asking for my fabulous vacation property realistic?”
Here are three common financial questions, and the ratios you can use to answer them.
Do I have enough money saved for emergencies?
Answer this question with a “Liquidity Ratio”:
Total Liquid Monetary Assets / Monthly Expenses = Liquidity Ratio
Divide your Total Liquid Monetary Assets by your monthly expenses. The answer is “Yes” if this number is a 6 or higher. If it’s lower than 3, the answer is “No”.
Other than my mortgage, am I carrying too much debt?
Answer this with the “Debt Re-Payments to Disposable Income Ratio”:
Monthly Non-Mortgage Debt Re-Payment / Monthly Disposable Income = Debt Payments to Disposable Income Ratio
Divide your Monthly Non-Mortgage Debt Re-Payment by your Monthly Disposable Income. The resulting number should be less than 0.14. If you get a number greater than 0.15, the answer is “Yes, you have too much consumer debt.”
Do I have too much debt overall?
Answer this question with the “Debt Service to Income Ratio”:
Annual Debt Repayments / Gross Income = Debt Service to Income Ratio.
Divide your Annual Debt Repayments by your Gross Income. The smaller the better when it comes to this number, but if it gets higher than 0.36, your answer is “Yes, you have too much debt overall.” Note that this number should decrease as you get closer to retirement.
If your financial world is making you dizzy, use debt, savings, retirement, real-estate, investment, insurance, or other financial ratios to improve your situation. They’re sure to stop the spinning!
What ratio would you like to try first?