Peter Drucker said it a long time ago – you cannot improve what you do not measure. In thinking about personal finance, our goal is to improve our position. Right. So what are we measuring?
Motley Fool offers 3 measuring tools that are worth knowing. They should not be used to impose hard and fast rules. But they are useful guides to assess whether your overall position is improving. The tools are
- Your liquidity ratio (divide the overall amount of your liquid assets by your monthly carrying costs)
- Your debt service ratio (the amount you must pay per month divided by your income before taxes). You can look at this as a percentage (and banks would recommend that you keep this below 40%) or in raw dollar terms
- Your assets to equity ratio — or leverage ratio — (dividing total assets by net worth). In the best of all worlds, you want this to be under 4.5 and declining over the course of your working life.
In a perfect world, you are liquid enough to cope with emergencies, with a manageable debt service ratio and are not highly leveraged. You can get into trouble any of these if you are not prudent.