A personal finance blog dedicated discussing such topics as budgeting, asset allocation, 401K, IRA, cash flow, insurance, financial planning, portfolio management, and other areas in personal finance.


Friday, April 15, 2005

Analyzing Your Financial Statements with Ratios - Part II

With my last post in this series, I talked about the Basic Liquidity Ratio (BLR). Today we will look at three Debt Ratios.

To be able to follow along with the calculations, you might want to have a copy of the net worth statement and the cash flow statement, which can be found in these two posts:

Net Worth Statement

Cash Flow Statement

Although ratios aren't the end-all to financial analysis, they can be a big help in pointing out trouble areas of a financial plan. They are also beneficial in looking at year-to-year numbers in order to look at trends.

Debt Ratios

Debt-to-Assets Ratio

Debt-to-assets ratio = total debt ÷ 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 ÷ $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%.

Debt-to-Gross-Income Ratio

Debt-to-gross-income ratio = annual debt repayments ÷ 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 ÷ $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.

Debt Service Ratio

Debt service ratio = annual debt repayments ÷ 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 ÷ $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.

So, there are three useful debt ratios to help you analyze your personal financial statements. We will continue with ratios next time. Please email me if you have any questions.