Math Skill 2 - Financial Statement Analysis

When we say we are going to perform a “financial statement analysis”, what we mean is that we want to calculate some ratios to decide if there are areas of our finances that could use some adjustment. While there are MANY ratios you could possibly use, we are going to focus on just a few in this book.

Ratio Formulas

You can use these ratios to determine your overall level of financial health. If you have a ratio that falls outside the recommended range, then you need to take action to start changing that ratio. For example, if your debt service ratio is too high, you will want to try to start repaying debts. If your liquidity ratio is too low, you will want to start adding funds to your savings account.

1. Net Worth shows your level of worth. It is best for this number to be greater than zero and to grow as you move forward through your life. The best way to increase your net worth is to save income regularly and to pay off your debts. It is okay for your net worth to be less than zero when you are young. It takes time for net worth to accumulate. Be patient.

2. The asset to debt ratio is found by dividing your total debt by your total assets. This ratio determines your solvency. If the ratio is greater than 1, then you are solvent. This tells you the same information as your net worth, and is interpreted the same way.

3. The investment assets to total assets ratio is found by dividing your investment assets by your total assets. This ratio indicates the degree to which you building your wealth. This ratio can be 10% or less in your 20’s, but should rise over time to over 30% when you are in your 40’s. Like net worth, it takes time for this ratio to increase.

4. The basic liquidity ratio measures if you have enough money in your emergency fund. It is calculated by dividing your liquid assets by your monthly expenses. You can interpret this ratio as the number of months you can live without any income before you run out of liquid assets. General recommendations are to have a basic liquidity ratio between 2 and 6 months worth of expenses. Too large of a liquidity ratio is bad because it means you are missing chances to grow your wealth. Too small is bad because it makes you vulnerable to emergencies and problems.

5. The debt service to income ratio is found by dividing your annual debt payments by your gross annual income. This ratio measures if you have too much debt for your income. This ratio should always be less than 36%, or you might start having trouble paying your bills.

Example 1

The Morrison family has provided you with the following financial statements. Calculate their Net Worth, Asset to Debt Ratio, Investment Assets to Total Assets, Liquidity Ratio, and Debt Service to Income ratio, and give them some recommendations.

Their net worth = Total assets – total liabilities. They have $5,100 + $2,500 + $22,800 = $30,400 in total assets. They have $10,600 + $12,400 = $23,000 in total liabilities. Therefore their net worth = $30,400 - $23,000 = $7,400. This is greater than zero, which is within the acceptable range.

Their asset to debt ratio is calculated by dividing their total assets by their total liabilities. Asset to debt = $30,400 / $23,000 = 1.32. This is greater than one, which is within the acceptable range.

Their investment assets to total assets = $22,800 / $30,400 = 75%. This is well above any of our recommended levels, so that’s good.

Their liquidity ratio is calculated by dividing their liquid assets by their monthly expense. Their monthly expenses = total annual expenses / 12 = $40,700 / 12 = $3,391 (we can round this to the nearest dollar). Their liquidity ratio is then $5,100 / $3,391 = 1.50. This is too low, so they should start saving up money in the savings account they use as their emergency fund.

Their debt service to income ratio is calculated by dividing their annual debt payments by their total annual income. Debt service to income = $10,800 / $52,100 = 0.21. this is less than 35%, so they do not have too much debt.

Our only recommendation to the Morrison’s is that they increase the amount of liquid assets that they have, by saving up some money in a savings account.

Watch it in action!

Practice Problems

Calculate the Net Worth, Asset to Debt Ratio, Investment Assets to Total Assets, Liquidity Ratio, and Debt Service to Income ratio for the following families:

Solutions