You may not realize it, but you're a CEO.
The moment you left school, you were promoted to the chief executive position of your own personal financial business. You're in charge of the budget, investment and debt decisions, strategy, and, ultimately, financial success.
To be the best personal-finance CEO you can be, you need a few tools to objectively gauge the condition of your finances. Here are three super-simple ratios that can do just that.
1. The liquidity ratio
In financial circles, the "golden rule" is a little bit different from what you learned in grade school. It states: "He who has the cash makes the rules." Therefore any assessment of your personal financial situation should start with cash.
First, there's the liquidity ratio, which is calculated by dividing the total of all the cash assets you have -- think checking accounts, savings, and non-retirement stocks and bonds -- by your total monthly expenses.
This ratio gives you a crystal-clear picture of how long you can sustain your family's financial well-being with your existing cash reserves in the event you lose your ability to generate income. As a rule of thumb, you should try to keep at least three to six months' worth of cash on hand for this worst-case scenario.
2. The debt service ratio
The second cash-centric ratio to use is your debt service ratio. This is more or less the same ratio banks use when assessing your application for a loan.
The debt service ratio is calculated by dividing the total of all your monthly debt payments by your total monthly income before taxes. For example, if you make $60,000 per year and have a mortgage of $1,500 and a car payment of $250, your debt service ratio would be 35%. That's $1,750 in total debt payments per month divided by your $5,000-per-month income before taxes.
You should analyze this ratio in two ways: as a percentage and in raw dollar terms.
As a percentage, banks will generally recommend staying below 40%; the lower the percentage, the better. Banks will sometimes approve your loan with higher percentages, but that doesn't mean it's financially sound to take on that much debt.
For many people, a target debt-service ratio should be much lower than the bank's 40% standard. If you can keep your ratio below 20%, you're doing a fantastic job. The reason has to do with the raw dollars that combine to create the percentage.
If you earn $1 million per year, you can easily handle a debt service ratio much higher than 40%, because you literally have hundreds of thousands of dollars in excess income. For someone earning $30,000 per year, a 40% debt service ratio would be considerably more difficult, if not impossible, to maintain.
Remember, this ratio considers only your debt payments. Your living expenses, retirement savings, taxes, utility bills, and all other expenses have to be paid from whatever money you have left after those loan payments.
3. The assets-to-equity ratio
If someone told you he or she had a $1 million net worth, you'd probably think they were pretty rich. But what if that $1 million net worth came from $100 million in assets subtracted from $99 million in liabilities? That person suddenly doesn't seem so rich, right? In fact, with $99 million in debt, he or she would probably be on the cusp of bankruptcy.
That's why the assets-to-equity ratio, sometimes called the leverage ratio, is so important. This ratio is calculated by dividing your total assets by your net worth.
Your personal residence is most often the most valuable asset you own, and it usually comes with a healthy dose of debt. If you pay a 20% down payment, that creates an assets-to-equity ratio of five, just from that single asset.
Your leverage ratio will probably change over the course of your working life as you pay down the mortgage on your home. Using a conventional mortgage as our baseline, you should seek to keep your overall leverage ratio below 4.5 early in your career and then ensure that it steadily decreases as you age.
To make that happen, try a combination of decreasing mortgage debt, avoiding other debt such as credit cards, and gradually increasing other assets such as stocks, bonds, and cash.
How do your finances stack up?
Using these three ratios, you can easily and quickly check the health of several critical aspects of your finances.
You'll know how prepared you are for an unexpected interruption of your income. You'll know whether you should focus on getting your debt service to a more sustainable level. You'll know whether you're making the most of your cash flow without taking on too much risk with too much debt.
Use these tools to check your finances today, but consider writing down the results and tracking them every few months. Tracking the trends over time will allow you to watch your finances improve and motivate you to keep up the good work.
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