Financial statements can be confusing with all the numbers they present. This chapter’s discussion is meant to help you answer the question:
What are the numbers that give you the answers and deeper insights critical to attaining financial success?
Financial indicators, or ratios, can help you acquire a deeper understanding of your financial situation and your financial health by providing numerical, measurable information about your situation.
Benchmarking is when you use these indicators or ratios to compare your financial situation to another person’s situation, to your past situation, or to your future goals. You use the indicators as benchmarks to measure your progress.
In fact, when you ask for an auto loan, or a mortgage, or a new credit card, financial institutions use these very same indicators and compare them against benchmarks so that they can understand your financial health and your ability to pay back the loan. If banks use them to understand your situation, why not use them yourself?
Although ratios and indicators may sound complicated, you can use a tool to calculate these numbers consistently. Don’t over-analyze or stress about the variety of ratios you will find in financial publications and online. In the end, all that matters is the answer to this question:
Are your ratios and indicators going in the right direction?
A Story from Chris: What if Your Life Depended on It?
I like to ski in the backcountry, off the main slopes and away from crowds. One challenge of skiing in the backcountry is that avalanche danger is always present. I try to reduce my chances of being caught in an avalanche by researching conditions such as recent avalanches, snowfall, wind, and rapid warming. The presence of any of these conditions increases the risk of avalanches. I let this information guide me to keep me as safe as possible as I travel through avalanche terrain. I also compare this information to my own observations as I travel toward my final destination. It helps me to determine if I will be skiing a 50 degree couloir or avoiding any slope of 25 degrees or more.
In finance, just as in the backcountry, circumstances matter.
Financial indicators give you facts you can rely on to understand your financial security and strength, just as snowfall, windspeed, and temperature trends inform me about the chances of avalanche.
Financial Indicators to Measure the Health of your Wealth
Financial indicators are typically grouped into categories that describe specific areas of a person’s wealth, such as short-term or long-term cash flow, net worth, and so on. Some of these calculations are more important than others, while some are not applicable at all depending on your financial situation and the complexity of your net worth. (Also, different benchmarks are used for individuals and for businesses because of the different types of risks each brings.)
Let’s focus on four of the most important indicators: Savings Rate, Net Worth, Debt Ratios, and Rate of Returns.
Your savings rate is by far the most important financial indicator to monitor and actually helps you see into your financial future. That is because your savings rate tells you how much of your income you are putting aside – to save for a rainy day, to pay down debt, to start a business, or to contribute to retirement. It is calculated by dividing savings over gross income.
Calculating, understanding, and improving your monthly savings rate is probably the most beneficial thing you can do to positively affect your wealth.
It is important to remember, however, that your savings rate is a short-term indicator and can easily be affected by spending choices. Low level expenditures one month will improve your savings rate, but an expense blowout the next month could drive it into negative numbers. People with a consistent savings plan tend to experience less financial stress and sleep better, and are able to provide for themselves rather than simply giving their hard-earned money to other people.
Your personal Net Worth is second in importance. Personal Net Worth is calculated by deducting all of your liabilities from all of your assets. Net Worth is a long-term number that often becomes more important to you as you age. It is the mass of your Net Worth that will provide for you when you retire. It does so in two ways. For one, the mass of your assets can generate income in the form of interest and dividends that, alone, may be sufficient to support you in retirement. Secondly, you can draw upon the principal of your net worth itself so long as you don’t overspend and draw the principal down too quickly.
Third, it is important to measure the level of your Personal Debt. As mentioned above, a portion of your Net Worth is your liabilities, or your debt. If you want to analyze the health of your wealth, reviewing your debt ratios is a great early step to take. Debt ratios describe your debt, as it compares to your income.
It is important to compare your debts to your income because, remember, every dollar that is being used to pay loans (and the interest on them) cannot be used for anything else. You cannot use that money to pay for groceries nor can you set it aside to use later by placing it into savings. The higher your debt payments compared to your income the less money you have available to grow your net worth
When considering whether to lend you money, financial institutions rely on these consumer debt ratios, among others, to measure your financial health and to assess your creditworthiness (or your ability to pay back the loan.) The better your indicators are, the better the chance you will get a loan, and the better the chance you will have of obtaining a loan at a lower interest rate, which in turn will reduce your payments. High personal debts will also strongly and negatively impact your credit score, which can affect your ability to obtain a loan.
Finally, the Return on your Net Worth is an important measure for people who live off or intend to live off of their Net Worth and who do not want to run out of money in their lifetime. This indicator analyzes the income you are receiving from your nest egg. Depending on your age, it will also include social security and pension income you may be receiving. Return on Net Worth is typically measured against all assets that make up your net worth. Often, an analysis and a comparison of each asset are made to determine return on dollars, risk assessment, tax consequences, and more.
Benchmark Indicators for Business
The main difference between consumer loans and business loans is that personal loans are made to consumers so they can purchase items for their personal use, enjoyment, and benefit, while commercial loans are typically used to grow a business.
Furthermore, consumer loans rely on the borrower’s income to repay the loan but business loans rely primarily on the cash flow created by the business to repay the loan.
For a business, carrying debt can prove a quite profitable endeavor for an enterprise if it enables it to grow faster or become more profitable. On the other hand, debt can be the reason a company goes under if the debt is used in ways that do not create enough profits to repay it, thereby causing the company to go out of business or declare bankruptcy.
Chris’s Take Away
When building your net worth, you must guide yourself by data analytics and not by emotions. Looking at your numbers—at your financial indicators–will help you decide if you should be paying down debt, practicing frugality, creating a rainy-day fund, investing, or focusing on the return of your net worth. Monitoring your financial indicators is incredibly important to your success. CalcuTrackTM can do that for you and be your guide. Let us help you get started!