“Always know the difference between what you’re getting and what you deserve.”
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How can we use ratios, like those used in corporate finance, in our lives as fathers?
Typically, a financial ratio is derived from financial figures and statements published by companies. We can use these ratios to guide our investment decisions. In terms of personal finance, we can use these ratios to calculate whether or not we can pay a bill, to gauge our levels of risk, tell us how much we make in relation to our assets, the companies in which to invest, and what future cash flows may look like. For more, check out our Google Sheet full of useful ratios, and our Resources page.
1. The Current Ratio (or Working Capital)
Take your assets and divide them by your liabilities. The current ratio is a good indicator of financial health and demonstrates your ability to pay short term debts owed. So, if you had to pay off your credit card tomorrow, how quickly could you do that based on your current assets and liabilities. A higher ratio result means you are more liquid. For example, say you have a steady income and a 401(k) that currently add up to $160k. Say you also have a mortgage payment and a car payment that currently add up to $80k. In this case, your current ratio = $160k / $80k = 2:1.
2. Debt to Equity
Divide your total debts by your equity (remember: Equity = Assets – Liabilities aka Debts). The debt to equity ratio is a good measure of how much a company borrows to acquire its assets. In terms of personal finance, this can be updated to Debt to Income. In a very simple example: How much credit card and car loan debt do you have vs. your income stream? Lenders, particularly in real estate, look closely at this ratio in determining whether or not to give you a loan, and how much they will give.
3. Return on Assets (ROA)
Divide your Net Income by your Assets to get your Return on Assets. You spent money to get those assets and now you want a return on them. This could be how much you spent on a house or college education. ROI is the term that gets the most attention, but in reality, you can make yourself and family wealthy by holding the assets that derive the greatest gains. The most important of these is likely your retirement account. Invest in your 401-K and always match. Save from your paycheck and put it in your self-funded IRA. A dollar saved is a few dollars when you need it later on. Check out this report by Aspen Institute on assets and their impact on driving wealth.
4. Return on Equity (ROE)
Divide your Net Income divided by your Equity. Remember: Equity = Assets – Liabilities. So, Return on Equity is your net income divided by equity. This is a profitability ratio showing how well you’re managing your profits, like investing in real estate or in the market. ROE will increase as your net income increases faster than your equity. On the other hand, ROE will decrease if equity rises faster than net income, or, worse, if net income decreases as equity rises. While this may shift often, you could think of rising ROE as the pay off for spending income earlier on a house and other investments that gain value beyond your income.
5. Price Over Earnings (P/E)
P/E ratio is a great ratio for investing, specifically in determining the worth of a company. Divide the price of the share by the earnings per share of a company over a period of time. It’s a fairly simple idea: the price to invest in a stock of a company is higher or lower than the amount the company makes. A high P/E ratio means the price of a stock is higher than its earnings. This could mean it’s overpriced, or that investors foresee great revenue and earnings growth in the future and people are investing. On the other hand, a stock may be undervalued with a low P/E ratio, which means the price of a stock is lower than earnings. In addition to being undervalued, it could be an indication that the market sees the company as failing, and revenue drying up in the future.
