Future Focus: Four financial ratios every household should know
Good context for your yearly review.
At the beginning of last financial year, my column ran through ratios to help answer the question – are you wealthy? This year, I look at the other side of the equation - a guide that help to identify risks before they become problems. Most people focus on their net worth as a measure of financial well-being. Knowing how much your house is worth, your super balance and your investment balance is a good start. However, that doesn’t tell the whole story.
A growing investment portfolio can disguise a deteriorating financial position if debt is rising even faster. A large super balance might look impressive, but it won’t help if you have no emergency savings or struggle to meet monthly expenses.
Here are four financial ratios that can give you a more complete picture of your financial health.
1. Liquidity ratio
Can you meet your obligations if something unexpected happens? The liquidity ratio will give you an understanding of whether you can.
Accessible cash ÷ monthly essential expenses
If your household keeps $45,000 in an offset account and spends around $7,500 each month on essential living costs, your liquidity ratio is six months.
This doesn’t mean your money should sit permanently in cash. There is an opportunity cost to holding cash as it generally earns lower returns than growth assets over long periods. The opportunity cost must be weighed against the benefits of cash – the liquidity provides flexibility if anything goes wrong.
Unexpected redundancy, illness, major home repairs or family emergencies rarely arrive at convenient or predictable times. Investors with adequate liquidity are less likely to be forced to sell investments during market downturns or take on expensive debt when life doesn’t go to plan.
The right level of cash depends on your circumstances. A dual-income household with secure employment may need less liquidity than a self-employed contractor with variable income. The ratio isn’t about chasing a magic number. It’s about understanding whether your household has enough breathing room.
I’ve written before on the underappreciated benefits of cash.
2. Savings ratio
Are you focusing on what you can control or do you rely on rising asset values to do all the heavy lifting? If it is the latter, you might want to look at your savings ratio.
Annual savings ÷ net household income
Just as this ratio can be an indicator of wealth, it can also be an indicator of risk. Markets receive far more attention than savings rates but your ability to consistently save is one of the few variables completely within your control. Australian life expectancy has risen 30 years in the last century. Most Australians need to save enough for a retirement that is likely to be the same duration as their working life.
My investment strategy focuses on the variables that are within my control, including my savings rate, behaviour and minimising tax and costs. It can make a much larger difference to your return outcomes than agonising over which of two similar investments is better.
This ratio also acts as an early warning system. If your income rises but your savings ratio remains unchanged, lifestyle inflation may be quietly consuming every pay rise. I’ve written about lifestyle creep and its dangers before here.
3. Leverage ratio
Borrowing isn’t inherently good or bad. Used sensibly, leverage allows households to buy homes, invest and smooth spending over their lifetime. It also magnifies risk.
Rather than focusing solely on the size of your mortgage or investment loans, consider your leverage ratio:
Total debt ÷ total assets
A household with $2 million in assets and $600,000 of debt has a leverage ratio of 30%. This provides additional context than simply saying you have $600,000 in debt.
Your leverage ratio should also be viewed alongside your capacity to service debt. Rising interest rates, changes in employment or growing family commitments can all make what feels like a manageable level of borrowing into a financial anchor.
Importantly, not all debt serves the same purpose. Borrowing to purchase appreciating assets may have very different long-term outcomes than borrowing to fund consumer debt or consumption. The ratio doesn’t distinguish between good and bad debt, but it encourages households to understand how much financial risk they’re carrying overall.
4. Concentration ratio
Concentration creates risk.
Many Australian households unknowingly have much of their wealth tied to a handful of drivers. Their income comes from one employer. Their largest asset is their family home. Their super and share portfolio are heavily invested in Australian equities. If they also work in banking or mining, they’re even more exposed to the same parts of the economy.
One simple way to assess this is to calculate:
Largest asset ÷ total household net worth
If your home represents 80% of your wealth, that’s useful information. It doesn’t automatically mean you’ve made a poor decision but it could help you to direct future savings. It is worth understanding how much of this wealth you stand to realise, and how concentrated your outcomes are on one asset.
I’m an example of how circumstance can lead to concentration. I’m an advocate for diversification yet a large part of my portfolio is concentrated in one holding – Morningstar MORN. It is part of my remuneration package.
I work in financial services, and my skills and experience are aligned to the industry. With over 30 years to go until I access my superannuation, my assets are heavily concentrated in equity markets, which locally are further concentrated in financials. I have a mortgage on a property in the Australian market.
I understand the concentration in my portfolio, but also the context of my multi-decade time horizon.
Concentration can work in your favour. Many of the best investment outcomes have come from investors having meaningful exposure to exceptional businesses.
This concentration does change the nature of risk. When a portfolio depends heavily on a small number of outcomes, the investor is no longer just taking market risk. Instead, the primary risk is an investor’s ability to assess if their specific investments are correct. This is not necessarily the incorrect path - some investors deliberately make concentrated bets because they have a high level of conviction.
It is important that the level of concentration in your portfolio is a considered decision, and not something that you have drifted into without noticing.
Concentration increases vulnerability. A downturn in one market, industry or region can have an outsized impact on your financial position. The objective isn’t to eliminate concentration altogether as this is an impossible task without a significant base of assets. Instead, it’s about recognising where it exists so future investment decisions can improve diversification over time.
Ratios are indicators and require context
As soon as you measure something it is tempting to automatically declare the result good or bad. The metrics I’ve outlined require context. There’s no ‘right’ range to fall into with any of these ratios. It all depends on your circumstances, your goals and creating balance in your financial life. In the case of the ratios I’ve outlined a focus on improving one may worsen another.
Holding more cash strengthens your liquidity ratio but may reduce long-term investment returns. Paying down debt lowers leverage but might delay investing elsewhere. Concentrating your wealth in a successful business may reduce diversification while substantially increasing your overall net worth.
These ratios are most useful when tracked over time rather than viewed in isolation. A single snapshot tells you where you are today, but repeating this process over time tells you whether you’re moving in the right direction.
Measuring what matters
Good decisions start with a good understanding of your circumstances. These ratios allow you to see your progress over time. Risks are as important to measure as successes. Successful investing isn’t just about growing assets, it is about building resiliency and flexibility to support the life that you want.
Use this simple framework for assessing whether their overall financial position is improving and your progress to building financial resilience.
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