I know what you are thinking…Sounds easy right? It’s just one number divided by another. In reality, it requires detailed bookkeeping to track all of your income, investments, loan accounts, and bills. But what about your mortgage–is the principal really an expense? How about that employer stock grant program that awarded you 50 shares for a price of $26.22 but withheld 18 of the shares to pay taxes, that you then sold the remaining 32 for $28.19 two months later? Not so easy, is it?
To properly compute the ratio, you need to build an income statement. An income statement is a document that tracks the inflow and outflow of cash over some set time period – usually a month, quarter, or year. For personal finance issues, a month is a good resolution to use.
The income statement contains two main parts – one for all the cash that comes into your household, and one part for all the cash that leaves your household. Transfers don’t count. So if you contributed some of your pay to a retirement account, it really doesn’t belong on an income statement. What does belong on the income statement is gross pay, not your net. Remember to include interest from bank accounts, dividends from stock, 401(k) employer match, and realized capital gains. Unrealized capital gains will affect your balance sheet, but should not show up on your income statement. All numbers should reflect pre-tax amounts. We can account for taxes in our expense column.
This second part – expenses – is usually the longer column in the balance sheet. Aside from your regular bills, be sure to include all of your monthly insurance costs, income tax, and payroll taxes that were deducted from your paycheck (even if they were in the form of stock); and any interest you paid on a loan. This brings us to an important point:
If your car payment was $460, then only the $60 or so that went toward interest on the loan was really an expense. The payment to principal was simply a transfer of your cash into equity in your car. Remember that transfers don’t count. The same concept applies to your mortgage and student loans of course. Keep in mind though, equity you build in a home tends to stay put or grow, but the equity that’s put into a car tends to evaporate over the next 5-10 years. It’s like filling up a bucket with a big hole in the bottom.
So after you’ve tallied up all of your gross income and all of your expenses for the month, you’re finally ready to divide one by the other. Hopefully, the ratio is greater than 1. Otherwise, you’re living well outside of your means and eroding your existing net worth. It seems like its simple, but its amazing how difficult most people find it in practice.