child with three fingers up representing 3 financial wellness ratios

3 financial wellness measurements you need to be checking regularly before it ruins your life

June 12th, 2019 Posted by Financial Wellness, How to 0 thoughts on “3 financial wellness measurements you need to be checking regularly before it ruins your life”

How do you currently handle your money situation?

Your mind might be racing with thoughts of 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, or maybe you were raised not to talk about money, don’t worry either way you’re in really good company and I can totally empathize.

Allow me tell a quick story from my side to see if you can relate and then I’ll share what I would consider life-saving learnings that most everyone will find really valuable.  More specifically, you’ll learn about three financial wellness measurements that if you measure and track regularly will help prevent you from falling in an unexpected money trap.  

Quick story about how not measuring my finances became an incredibly costly life lesson

If we rewind the years back, I was living a good life out of college. I’m still in my late twenties and climbing the corporate ladder quick while making what I would consider great money at that age. I thought I was pretty smart with my finances. I used Mint.com to track my expenses, investing in 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 when I was forced to make heavy withdrawals (with substantial penalties) from my 401k to cover fixed living and debt costs while I looked for new work.  

Apparently, having a high income, rocket-ship career trajectory, 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.

Sum total, this poorly planned life path decision cost me thousands of dollars in penalties not to mention the incredible loss in compounding interest momentum.  I legit don’t think my retirement savings will ever completely recover from that blow.

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 $10,000 in their savings account. Would you say they’re doing well? I bet if we asked a dozen random young adults off the street, they’d say “sure, they’re doin alright!”.

What if you had more information – such as Jane lives modestly with roommates in a rental house. Her monthly budget is about $1,750 for everything. Meanwhile, Tom lives big and spends on average $5,200 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?

Imagine that instead of telling you how much they each have in their savings accounts, I told you that Jane and Tom have cash ratios of 5.7 and 1.9 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.

The power of measuring the right things

This is the magic of ratios. Ratios take multiple factors – i.e. savings AND spending habits – and tie them together to give us a more well-rounded understanding of how things are doing.

After years of reading, calculating, and discussing this topic with peers and experts, we believe that for young adults it all starts with monitoring three 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.

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, the chances of you following a stable and healthy financial life will be much better.

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 overall financial wellness.  

How to calculate Lifestyle Surplus ratio:

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.  To really make sure we’re capturing perspective on all the “miscellaneous” stuff that may only come up every few months or once a year, I usually will take the last 12 months expenses and divide by 12 to compare against and make sure I don’t need to make any additional adjustments to account for the difference.

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, get a roommate, eat out less, drink water out of the tap, negotiate your insurance costs down, get a side hustle, 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 Emergency Funding (slightly modified Cash Ratio) 

Emergency Funding is the next most important aspect.  Think of it as simply measuring how long you can cover your financial needs if your flow of income was cut off today.  In the personal finance world, this can be represented by a cash ratio.

The primary difference is that the textbook 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 human nature is we’ve all convinced ourselves that stuff we’re spending money on IS a must have.  If you’ve ever weighed the pros and cons of cancelling your gym memberships or netflix accounts, I think you know what I mean. 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 plan using the same “Cost of Lifestyle” number you used above in #1.

How to calculate Emergency Funding ratio:

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: 3-6 months

What if my measure is less than 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 my measure is over 3 months?

That’s awesome. Ideally, keep pushing it upwards of 6 months.  But you can ease up a little to start sending some funds toward 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 have tried really hard to protect 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”?

Basically, it’s your total net worth, but averaged up against what you own.  This is a process called normalizing which lets us compare apples-to-apples regardless of circumstance.

How to calculate Solvency ratio:

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)

Net Worth = (Total Assets) – (Total Liabilities)

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 you can sleep easy my friend! 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.

What’s next?

  1. Calculate each of the above measures.
  2. Track in a monthly journal.  Or, set a recurring monthly meeting in your calendar for a half hour to run these calculations 
  3. Focus on improving in small increments until you feel safer. When you take your measurements, go ahead and write down a couple sentences for how you plan to improve.  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.  We have a method for this too, however, it’ll take a bit more discussion and as such we’ll talk about it in a future 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!

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