Key Financial Ratios

Financial ratios are quantitative tools that help CFP professionals evaluate a client's financial health, identify potential problems, and measure progress toward goals. The CFP exam tests your ability to calculate these ratios and interpret their meaning. Financial ratios are grouped into three categories:

1. Liquidity Ratios - Measure ability to meet short-term obligations
2. Debt Ratios - Indicate how well a client manages their debt
3. Performance Ratios - Assess financial flexibility and progress toward goals

Liquidity Ratios

Liquidity ratios measure a client's ability to meet short-term financial obligations without selling long-term assets or taking on additional debt.

Current Ratio

The current ratio measures the ability to pay current liabilities with current assets:

Current Ratio = Current Assets / Current Liabilities

What counts as current assets:

• Cash and checking accounts
• Savings and money market accounts
• CDs maturing within 12 months
• Marketable securities that can be quickly sold
• Accounts receivable

What counts as current liabilities:

• Credit card balances
• Bills due within 12 months
• Short-term loans
• Current portion of long-term debt

Example Calculation:

• Current assets: $16,500 (checking $5,000 + savings $10,000 + CD $1,500)
• Current liabilities: $3,000 (credit cards $1,500 + bills $1,500)
• Current Ratio = $16,500 / $3,000 = 5.5 (Excellent)

Exam Tip: A ratio of 2.0 is generally considered reasonable for the current ratio.

Emergency Fund Ratio

The emergency fund ratio measures how long a client could sustain their essential lifestyle without any income:

Emergency Fund Ratio = Liquid Assets / Monthly Non-Discretionary Expenses

Key distinction: Use only non-discretionary expenses (essential costs that cannot be eliminated: housing, utilities, food, insurance, debt payments). In an emergency, discretionary spending (entertainment, dining out, vacations) should be eliminated.

Example Calculation:

• Liquid assets: $30,000
• Monthly non-discretionary expenses: $5,000
• Emergency Fund Ratio = $30,000 / $5,000 = 6.0 months

Debt Ratios

Debt ratios indicate how well a client manages their debt load. These ratios are particularly important for mortgage qualification.

Housing Ratio (Front-End Ratio / 28% Test)

The housing ratio measures housing affordability as a percentage of gross income:

Housing Ratio = Monthly Housing Costs (PITI) / Gross Monthly Income

PITI includes:

• Principal payment on mortgage
• Interest payment on mortgage
• Taxes (property taxes)
• Insurance (homeowner's insurance)

Target: 28% or less

Example Calculation:

• Monthly PITI: $2,100
• Gross monthly income: $8,000
• Housing Ratio = $2,100 / $8,000 = 26.25% (Within target)

Exam Tip: The 28% housing ratio is sometimes called the "front-end" ratio because it only considers housing costs.

Total Debt-to-Income Ratio (Back-End Ratio / 36% Test)

The total debt-to-income ratio includes all recurring debt payments:

Total DTI = (Monthly Housing Costs + All Other Monthly Debt Payments) / Gross Monthly Income

Other debt payments include:

• Auto loans
• Student loans
• Credit card minimum payments
• Boat/RV loans
• Personal loans
• Alimony/child support

Key Benchmarks:

• 36% - Traditional conservative benchmark
• 43% - Maximum for most conventional mortgage qualification (QM standard)

Example Calculation:

• Monthly PITI: $2,000
• Auto payment: $500
• Student loan: $300
• Gross monthly income: $8,333
• Total DTI = ($2,000 + $500 + $300) / $8,333 = 33.6% (Good)

Summary of Key Debt Ratio Benchmarks

Exam Tip: These are the two most commonly tested ratios. Remember: 28% for housing alone, 36% for all debt. Lenders may allow up to 43% but this is considered high risk.

Performance Ratios

Performance ratios assess a client's financial flexibility and progress toward long-term goals.

Savings Rate

The savings rate measures the percentage of income being saved:

Savings Rate = Annual Savings / Gross Annual Income

Savings includes:

• 401(k) contributions (including employer match)
• IRA contributions
• Other investment account contributions
• Bank savings account deposits
• Education savings (529 plans)

Example Calculation:

• 401(k) contribution: $15,000 (including $5,000 employer match)
• IRA contribution: $7,000
• Taxable savings: $3,000
• Gross annual income: $125,000
• Savings Rate = ($15,000 + $7,000 + $3,000) / $125,000 = 20% (Excellent)

Important: Include employer contributions (match) in savings calculations. These are part of total compensation and represent real savings toward retirement.

Solvency Ratio

The solvency ratio measures overall financial health by comparing net worth to total assets:

Solvency Ratio = Net Worth / Total Assets

This ratio shows what percentage of assets the client actually owns (as opposed to owing to creditors).

Example Calculation:

• Total Assets: $655,000
• Total Liabilities: $306,500
• Net Worth: $348,500
• Solvency Ratio = $348,500 / $655,000 = 53.2% (Good)

Complete Financial Ratio Reference Table

Using Ratios in Financial Planning

Financial ratios should be used as part of a comprehensive analysis, not in isolation. When evaluating a client's financial health:

1. Calculate all relevant ratios to get a complete picture
2. Compare to benchmarks but consider individual circumstances
3. Look for trends by calculating ratios over time
4. Identify problem areas that need attention
5. Prioritize recommendations based on which ratios are most concerning

Example: Ratio Analysis Leading to Recommendations

A client has the following ratios:

• Emergency Fund Ratio: 1.5 months (Inadequate)
• Housing Ratio: 32% (High)
• Total DTI: 45% (Excessive)
• Savings Rate: 5% (Minimal)

Analysis: The client is over-extended on housing costs, which is limiting their ability to save and build an emergency fund. The high DTI suggests they may have difficulty obtaining new credit if needed.

Recommendations:

1. First priority: Build emergency fund to at least 3 months
2. Consider refinancing or downsizing to reduce housing costs
3. Focus on debt reduction before increasing savings
4. Increase savings rate as debt payments are eliminated

CFP Board Emphasis: The exam tests not just calculation of ratios but also interpretation and appropriate recommendations based on ratio analysis.