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.


Wednesday, April 20, 2005

Analyzing Your Financial Statements with Ratios - Part III

Today we will wrap up ratio analysis. In parts I & II, we talked about liquidity and debt ratios. Today we will talk about savings and growth ratios.

Savings Rate Ratios

The only way to build financial security is to save and invest income rather than use it for current consumption. Savings rate ratios tell us how much much is being saved and invested.

Investment-Assets-to-Net-Worth Ratio (IANW Ratio)

IANW Ratio = investment assets ÷ net worth

We find this information on the Net Worth Statement. Looking at the net worth statement, we see that the total investments are $335,000 and the net worth is $393,000. Plugging these numbers into the formula we get the following:

IANW Ratio = $335,000 ÷ $393,000

IANW Ratio = .8524 or 85.24%

This ratio tells us that this couple's investment assets make up over 85% of their net worth. This is a very good percentage. The closer you get to retirement, the higher this number should be. It is important to remember NOT to include investments that may be set aside to meet a certain goal (like a college education or new car or something like that). The more conservative and truthful you are in valuing your assets, the better.

Savings-to-Income Ratio

How much of your income are you allocating to savings? This ratio will help you gauge that.

Savings-to-income Ratio = amount saved ÷ annual income

This information is located on the Cash Flow Statement. We can see that this couple puts $12,000 per year in their 401(K) and another $6,000 per year away in investment plans. We will assume that the $4,500 going into education is funding education expenses and is not considered "savings." The annual income for this couple is $107,000, for the following equation:

Savings-to-income Ratio = ($12,000 + $6,000) ÷ $107,000

Savings-to-income Ratio = $18,000 ÷ $107,000

Savings-to-income Ratio = .1682 or 16.82%

This couple is currently saving nearly 17% of their income. This is a good amount to be saving, especially when you consider the fact that they are paying off their mortgage and student loans. Once these two obligations are taken care of, this couple should be able to save an even higher percentage.

Real Growth Ratios

"Real Growth" is growth adjusted for inflation. When people talk about real returns on investments, they are talking about the investment's return minus the inflation rate.

Growth of Income Ratio

Did your income keep pace with inflation? This ratio will tell you:

Growth of income ratio = [(income this year - income last year) ÷ income last year] - inflation rate

Since this is a hypothetical example, we'll have to make a couple of assumptions. First, we'll say that last year's income was $103,000 and that the inflation rate was 3.5% (.035 as a decimal). We saw from above that this year's income was $107,000.

Growth of income ratio = [($107,000 - $103,000) ÷ $103,000] - .035

Growth of income ratio = [$4,000 ÷ $103,000] - .035

Growth of income ratio = .0388 - .035

Growth of income ratio = .0038 or .38%

This couple's growth in income narrowly beat the inflation rate.

Growth of Net Worth Ratio

Is the growth in your net worth keeping pace (hopefully BEATING) inflation?
Growth of net worth ratio = [(net worth this year - net worth last year) ÷ net worth last year] - inflation rate

Once again, we will have to make a couple of assumptions. We will assume that last year's net worth was $340,000 and that the inflation rate was again 3.5%.

Growth of net worth ratio = [($393,000 - $340,000) ÷ $340,000] - .035

Growth of net worth ratio = [$53,000 ÷ $340,000] - .035

Growth of net worth ratio = .1559 - .035

Growth of net worth ratio = .1209 or 12.1%

This couple's net worth had a real growth rate of 12.1% last year. This is a very good growth rate. Maybe this couple is taking on too much risk? We can't know that without further analysis.

So, there you have it! That's it for the ratio analysis of financial statements. Where do we go from here? You'll have to check back and see!