Evaluate your Finances Like a Financial Analyst

As you travel along your journey to financial independence, it is enticing to only focus on your net worth and reaching some goal you’ve set for yourself in the future. However, to really assess the health of your finances and ensuring the best odds of hitting your financial goals, there are other metrics as well that you should at least be monitoring. To get an idea of what metrics to look at, we head to the headquarters of assessing the financial health of organizations: Wall Street.

Financial Analysts make livings on finding the companies that are going to increase their value (also known as Net Worth) in the shortest, most stable way possible. I’m not arguing that Wall Street is any good what they do (see: Index Funds: The Gold Standard of Stock Market Investing), but we can still find the things about Wall Street that do work well and use them to our advantage. One body of research we can use is around metric. There are several basic metrics that the Financial Analysis use to assess the health and future potential of a company. By adopting those metrics slightly, we can apply them to our own finances and paint a picture of how we’re going.

Current Ratio

The current ratio is used by Financial Analysts to determine if a company can cover it’s financial obligations over the next year. This is calculated by taking cash and cash-like assets, and dividing them by all debts that need to be paid in the next year. A current ratio of 2:1 is considered “healthy” for a company.

The current ratio in personal finance language is equivalent to the health of your emergency fund. In my post The Emergency Fund: Insurance for your Financial Life, I talk about my recommendation for how much emergency fund you should have, as a ratio of savings to monthly expenses. Our current ratio is somewhere between 4:1 and 6:1 (in months).

Current Ratio Bands:

0:1 – 3:1 – Aggressive, I hope you feel very safe in your career

4:1 – 6:1 – Healthy

7:1 – 12:1 – Too Conservative, invest some of that cash

Revenue Growth

The obsession with growth on Wall Street, IMO, is one of the primary faults in the investing and business world. The pressure for growth leads companies to expand into areas they have no business being in, acquire companies they know nothing about, and sometimes cheat their employees and customers (ex: Wells Fargo). However, growth does play an important role in the health and wellbeing of a business. As the saying goes, if you’re not growing, your dying.

To reach financial independence, it is important to be constantly looking for ways to grow your salary (aka. revenue). This can be in the form of side hustles, taking on extra responsibilities at work, or moving into a career with higher salary potential. While salary growth isn’t everything, and there can be tremendous benefits to switching careers into a lower paying field that brings you greater satisfaction, you should still be pursing salary growth opportunities whenever possible.

Revenue Growth Bands:

<3% per year: Look for additional opportunities to grow your salary

3%-10%: Congratulations, your salary is growing faster than inflation and you’re seeing solid earnings growth

>10%: You’re a rockstar at growing your salary, keep it up and you’ll be rich in no time

Net Income Growth

Net income growth is very much related to revenue growth, though it takes costs into account as well. Revenue costs company money in the form of additional cost of goods sold, selling expenses, maybe needing to open a new store, hiring additional people, etc. The mission for companies is to grow their net income faster than their costs, leading to greater net income at the end of the day. This money can be used to grow the company faster or be returned to shareholders. Historically, net income has grown at 8% per year (wait, isn’t that how much stock returns we should be expecting?).

Finding ways to increase your saving rate (income left over after expenses) can have a tremendous impact on your time to financial independence and early retirement. (see: Your Savings Rate and Your Net Worth.) Increasing your savings rate from 10% to 20% can cut your time to retirement by 10 years! Luckily for you, net income growth can come from two places, reducing your spending and increasing your earnings. With 2x the opportunities to increase your savings rate, you will always have something you can do to grow your savings rate. Keep reading this blog and hopefully you’ll learn a few things you can do from the steps that I’ve taken.

Savings Rate Bands:

<15%: You’re saving for retirement, which is good. But don’t expect to retire much before you hit 65. There are probably lots of ways to increase this rate.

15%-30%: You’ve done the basics of reducing your spending and raising your salary. Time to dig into some of the more challenging opportunities.

>30%: Nicely done! You’re on your way to an early retirement. Keep looking for more savings growth opportunities and see how high you can get your number.

Return on Assets

The fundamental reason a company exists in the first place is to take money and make more money with it. Some companies are more successful than others and ultimately determines the fate of companies. Return on assets is one measure how successful a company is at earning money given the amount of money it has to make it. It is a relatively simple equation, Net Income / Total Assets.

To grow your net worth fast enough to retire early, it will take more than a good income. You need to take your savings and use them productively, to grow them through the amazing force that is compounding. Stocks, bonds and real estate are just a few of the investments that can be used to grow your net worth. To see how productive your assets are, take all sources of non-salary income (dividends, rental payments post-expenses, interest, etc.) and divide them by your total net worth.

Return on Assets Bands:

<5%: Re-evaluate your investments. You may have too much cash, or be too conservative with your funds (particularly if you’re young).

5%-10%: This is a reasonable expectation of total asset returns for a diversified portfolio

>10%: You’re an investor equal to Warren Buffet and Benjamin Graham.

Note: over the short term, ROA can be very volatile, particularly if you own a lot of stocks. This metric is best assessed over longer periods of time (ex. 5-10 years).

Operating Cash Flow

When evaluating companies, operating cash flow is a key metric. It measures how much cold-hard cash is being generated by normal business operations (as apposed to raising cash by selling assets or taking on debt). This can be a strong indicator of whether a company can generate enough cash to grow it’s business, or if it will need financial assistance through issuing debt or equity.

While generating cash flow is less important in your early years of investing, it grows increasingly more important as you near retirement. The ability of your investments to generate income in the form of dividends, rents, or interest can be a strong indicator of how long your assets will last you in retirement. For instance, if you are invested entirely in stocks that pay no dividends, the only way to raise cash for yourself is to sell of assets, or stocks. However, if your dividends and interest are able to cover your entire retirement spending, you will never have to sell any of your assets (the ideal scenario for any early retiree).

Operating Cash Flow Bands as % of Assets:

<2%: Don’t worry if you’re early in your financial journey when asset accumulation is more important. However, those near retirement should look for investments that drive more cash flow

2%-4%: You’re in a good place. Following the 4% retirement rule, you’ll only need to draw down your assets slightly and should be in good shape for a healthy retirement

>4%: If you’re able to keep this up over long periods (such as through real estate investing) you could go the rest of your life without touching your assets; Well done!

 

How do you perform in each of these metrics? Are you set up for early retirement success?

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