5 key personal finance metrics you can make use of

personal finance metrics

Personal finance metrics refer to the various means used to evaluate the health status of our finances. As investors, it is essential that we examine the performance of our finances on a regular basis in order to continuously improve on them. In fact, the list of personal finance metrics can be numerous- some interesting, others complex. Selecting a few, but practical key metrics to track your finances, would therefore be in the right direction. Below are five of the key personal finance metrics that you can take advantage of.

  1. Living expenses (LE)

Living expenses appear to be one of the basic personal finance metrics known. Nevertheless, its key role in personal finance management cannot be understated. Living expenses encompass the general expenditure that we make on a daily, monthly, and annual basis. We all spend (whether directly or indirectly) to sustain the life that we live. In reality, living expenses vary from one month to the other depending on the nature of the expenses. Thus, it is practical to use average living expenses instead. The average of at least 6 months expenses can be fairly good. This can be estimated by tracking your expenses over some months. (Refer to this post on budgeting for further information)

Evaluating your living expenses can be of great benefits. You need to have a clear idea of your living expenses in order to estimate how long your investment can last. For instance, assuming the value of your investment is GH¢3000 (with no debt), a monthly living expenses of GH¢500 would imply that the GH¢3000 worth of investment may be able to cover your expenses for 6 months.

There is also a relationship between your living expenses and your savings rate, another personal finance metric discussed below.

  1. Savings rate

Savings rate refers to the percentage of one’s income reserved in the form of savings or investment for future use.

In mathematical form, Savings rate = (Reserved income/Total income) × 100

For example, if your total monthly income is GH¢500 and you reserve GH¢100 as savings, your savings rate will therefore be (100/500) × 100 = 20%

As mentioned earlier, your savings rate is affected by your living expenses. The lower your living expenses, the higher your savings rate and vice versa. Honestly, I don’t believe in any rule of thumb that defines the percentage of income one must save. I only believe in one principle: “Save as much as you can, even if it is 80% of your income.” Refer to the post below for further details:

Why the percentage-saving rule may not be practical

It is important to regularly evaluate your savings rate as it impacts the continuing growth of your investment. Higher savings rate can facilitate the rate at which your investment grow. If you realise a decline in your savings rate, you may fine-tune your expenses to get back in track. Consider taking a keen look at some taken-for-granted habits such as food waste to reduce cost. Finally, resist any attempt of falling prey to lifestyle inflation.

  1. Personal inflation rate

Do you realise that most of the inflation figures reported by the Ghana Statistical Service vary from the actual rise in cost of your expenses? Well, some even argue that it is due to the institution being politically aligned. You must not forget one thing though- The basket of goods used by the statistical service for the inflation calculation could differ from your spending pattern. For instance, they may have utilised the cost of beans, which is not your favourite staple food, in their computation. They may have also neglected the cost of flaxseeds which is rather what you buy most (if you have a foreign taste). That is why estimating your own inflation (personal inflation rate) is vital- You get to know the true reflection of your increase in cost.

Personal inflation rate compares your present living expenses to a previous one. Ideally, it must be annually based. That is, you compare your average living expenses in the present year to that of the preceding year. A positive personal inflation rate shows an increase in expenses in the current year while a negative rate denotes a decline in expenses.

Mathematically, Personal inflation rate = [(LE2/LE1) × 100]-100, where LE2 is Present living expenses and LE1 is previous living expenses.

For example, if your average living expenses in 2016 was GH¢450 while that of 2015 was GH¢400, your personal inflation rate for the year 2016 would be [(450/400) × 100]-100, which is 12.5%. What this means is that your expenses in 2016 exceeded that of 2015 by 12.5%

Personal inflation is inevitable, although can be kept under control. Knowing your personal inflation rate can serve as guidance to suppress your lifestyle inflation.

  1. Net worth

In simple terms, Net worth = Assets – Liabilities

Net worth is also considered as one of the most vital personal finance metrics. It expresses your overall material wealth which can serve as a guide in your financial decisions. Net worth is explicitly discussed in the link below:

The importance of knowing your net worth

  1. Freedom Ratio (FR)

Freedom ratio = Passive Income/Living expenses (PI/LE)

Passive incomes are earnings solely gotten from investments and include dividends, interests, rentals, royalties, and businesses of which one is not actively engaged. The regular interest you receive on your Treasury bill investment, the annual returns you get on your mutual fund investment, as well as that monthly (or probably annual) rental you collect from your tenants can be considered as a passive income.

Freedom ratio seems to be one of the most important personal finance metrics for individuals seeking financial independence. It actually

spices up the usefulness of the net worth for people who dream to live off passive income alone. That is, individuals who plan to switch their income from an active source to a passive source. By knowing your freedom ratio, you would be able to determine how close you are to financial independence.

As depicted in the equation, in order for your passive income to cover much of your expenses as possible, your freedom ratio must be closer to 1. If your freedom ratio is exactly 1, it implies that the passive income from your investments exactly matches your expenses.

The importance of knowing your net worth

net worth _sikasem.org
net worth-assets vs liabilities
Your assets vs liabilities

I bet one most tough question for many people to answer will be ‘how much is your worth?’ Not just because we don’t know the theoretical definition of ‘worth’ but because only few people pay attention to knowing their worth. ‘Worth’ expresses the overall value of all your assets put together. Often important is net worth which is commonly used to express one’s material wealth. Net worth is calculated by subtracting your total liabilities (debts) from your material worth (the value of all your assets).

In a simple format, Net worth = Assets – Liabilities

Your assets may include cash, investment accounts, stocks, real estate, personal car, owned business, etc. On the other hand, your liabilities include loans, mortgages, outstanding utility bills, credit card bills, etc. Depending on how accurate you estimate your assets, the resulting net worth may be inflated or undervalued. Inflating your net worth can have a negative implication on your financial decisions. For instance, you may be withdrawing too much from your investment account after realising that your net worth has been increased tenfold (although highly inflated) which can lead to a sudden plunge in your investments. To avoid inflating or undervaluing your assets, it may sometimes be necessary to seek the services of a professional to get accurate value of major assets such as your home.

Your net worth can be either positive or negative. Positive net worth shows that the value of your assets exceeds your liabilities. In contrast, negative net worth implies that your liabilities exceed the value of your assets.

See also: Does it matter how much we earn?

Significance of net worth

Net worth remains one of the most important metrics in personal finance. It gives a picture of your financial life at a particular point in time. You can use it as a gauge in your personal finance progress. Knowing your net worth over a time period is essential to determine your financial position. This can serve as a guide in your financial goal decisions. Basically, every positive financial decision can lead to an increase in your net worth. The opposite also holds true. A steady increase in your net worth over a period of time indicates a positive financial position. A negative net worth can even be used as a wake-up call to reposition your financial situation.

Depending on your financial situation, your net worth can fluctuate from month to month. Thus, even though computing your net worth on a monthly basis is laudable, the computed figures can be more meaningful over a long term such as a year.

The significance of your net worth may also depend on whether you’re actively working or not. While you are actively working, your net worth may not seem that relevant, all because you may still be having a dependable source of regular income to survive on. However, it becomes a companion to rely on when one is out of the job market (either through retirement or job loss). Without a dependable social security or pension plan, you will ultimately need to depend on your net worth to cater for your expenses.

The bottom line

The bottom line is that it is important for everybody who cares about his personal finance to compute his net worth once in a while. By knowing your net worth and for that matter your financial situation, you can be more careful and review your financial decisions in order to realise your goals.