There are only two types of success, and either may be experienced in any facet of our lives. They are contentment and progress. While there is much to be said about both, the intent of this writing in particular, is to offer a tool by which you may measure one or the other as they pertain to your personal finances.
Here's the exercise:
On the top of a piece of paper (or spreadsheet), begin listing all of your personal, non-depreciating assets and next to them, their values. This could be a number of things, but examples include housing or real-estate that you own, businesses that you own, brokerage accounts, retirement accounts, bank accounts, fine art, collectibles, etc.
Note that clothes, shoes, cars, TVs, furniture... and really any other typical consumer goods are not included. Why? Because by their definition, they are consumed! As they are used, they decrease in value. Makes sense, right? Exclude anything that naturally decreases in value. (For those of you advanced enough to understand the effects of inflation on a non-interest bearing bank account... We're only looking for a snapshot, and bank accounts count.)
Now, add the value of all of those non-depreciating assets, so that you have one lump-sum figure.
Next, at the bottom of the page, begin listing your liabilities and their values. These are credit cards, student loans, auto loans, personal loans, mortgages, or any other expected and agreed upon future outflows of cash. That's pretty all-encompassing, but take the definition seriously. If you owe money, you know it's coming out at some point, and you must be honest with yourself about adding it to the list. Here's an example... You just signed a lease on an apartment for a year, if your rent is $1000 per month, you should add $12,000 to your liabilities (though it will decrease each month). Don't worry about your other monthly bills, they don't belong on a balance sheet. Even a lease on an apartment is questionable, but it's important to know the effect of renting on your financial health. Only 7% of the wealthy rent their living space.
When you're done, add up all your liabilities so you have a lump-sum figure here as well.
Okay... Pretty simple exercise, right? Now, what does it mean??
In the world of corporate finance, the term current ratio is used to describe a firm's ability to pay it's short-term debt in an instance where that debt became immediately due. In personal finance, you can do the same thing by taking your liquid assets and dividing them by your short-term liabilities. In this case, however, we're not as interested in your short-term liquidity as we are in determining where you are, overall, in your financial life.
So we're going to take all of your assets (the lump-sum figure from the top of the page) and divide it by the total of your liabilities (the lump-sum figure from the bottom of the page). We're going to call this your Financial Health Ratio.
Don't worry about what the figure is, for now, but let's learn about why it's important.
Did you know that most Americans will consider you "rich" if you make more than $120,000 per year? We use income (or personal revenue) as the basis for determining whether or not somebody achieves a certain status, and we do so because, for the most part, it's all we can see. In business (where money is assessed and treated the way it should be treated in personal finance), without taking other things into context, your revenue says almost nothing about the financial health of your organization. It's possible to make millions of dollars... and go bankrupt. The same is true of personal finance. Did you know that 78% of NFL players and 60% of NBA players go bankrupt within 5 years of leaving the league? Also, a 2010 study suggested that the larger your lottery winnings, the more likely you were to go bankrupt in the next 5 years?
The lesson is pretty straightforward; what you make matters less than what you do with what you make.
Now let's go back to our Financial Health Ratio. There is no standard that determines whether or not you are financially healthy, only that the larger this ratio is, the better. Let's take a look at why.
Suppose you take out $10,000 in credit card debt, and you use that debt to purchase clothes, shoes, TVs, expensive bending phones (sorry Apple) and the like... If you have no other cash or assets, your ratio is zero. What's more? You've actually created an environment where your ratio will remain at zero for a prolonged period. Why? Because let's say you get a paycheck and use it to pay down $1000 of the debt, but use the rest to pay your other bills. You still have zero assets (no cash in the bank), and your debt is now $9,000... Your ratio is $0.00/$9,000... You can see how easily this cycle can get out of control and you can end up in a place where improving your financial health becomes very difficult. This also serves as a great example of why you must learn to pay yourself first!! Putting cash away immediately improves your ratio, even if you're only going from zero to 0.01.
On the other hand, let's say you buy a house for $300,000. You have to save for the down payment; anywhere from $10,500 to $15,000, and it's important to stop here. While you're saving this money, your bank account balances are increasing, and your ratio is likely already improving. Then you buy the house, so you have an asset worth $300,000, and you have a loan (liability) of approximately $290,000. You don't have the cash anymore, but you do have an appreciating asset with a value greater than the loan or liability you created to acquire that asset. What's more? (I like that phrase) Real estate has a long-term tendency to appreciate in value, and you're going to be paying the loan down month-by-month, so in the long run, your ratio will continue to improve. This sets in motion a cycle of financial health improvement that is necessary for true financial freedom (the cycle, not the house).
With that said, here's a synopsis... Increasing the ratio creates a cycle by which the ratio continues to increase. Likewise, decreasing the ratio creates a negative cycle that can become very difficult to escape.
So what about me? I have a ratio of almost exactly .75. My wife and I own a home, but I went to grad school, and created significant liabilities for myself without creating any true assets that increase the ratio. Ooooh... Did we just broach another subject??? The value of formal education in this assessment? In the next post, I'll discuss the value of different assets, and which ones accelerate positive cycles more than others.
For the time being, if you're going to take anything away from this post, take this... There are two types of success; contentment and progress. Once you've determined your Financial Health Ratio, you have a choice. Be content with it (which is a success), or make a decision to do one thing that will improve your ratio. Going from .75 to .77 is success. And then the decision must be made about how to go from .77 to .78, or whether you're just plain content with .77...
Thanks for reading! I appreciate your time (it's the greatest asset you have, by the way)!!
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