Following my previous posts on retirement (here and here), I’ve been thinking about how to measure how far along one is on the Financial Independence ladder. Measuring your financial fitness is also useful to gauge which areas you need to improve on. While I’m sure that this is as much an art as it is a science, it’s helpful to be able to quantify some of these measures or have some sort of benchmark to compare against.
Many others have already attempted to answer this question and I have drawn inspiration from the works of many other people who have tried to answer this question. If there are any errors in my interpretation of their work, I apologise in advance.
Some ways to measure your financial fitness
Kyith from Investment Moats has this post on what he calls the “11 stages of wealth”. It’s a linear way of measuring one’s financial fitness and I think the nice thing about this is that it’s easier for most people to think in linear terms. I’m not sure I completely agree with this way of representing things because it’s not so clear that some levels come before others. For example, level 6 states that “wealth is 10 years worth of current annual expenses” while level 7 is “wealth’s annual cash flow is greater than annual basic survival expenses”.
I’m not sure why level 7 is after level 6 and to me, one seems like a stock measure while the other is a flow measure. For non-finance people, you may think of this as one metric measuring how much water is there in a storage tank while the other measures how much water flows out of the water tank. The two measures are related but they mean very different things. For example, you could have a lot of water in the tank but if the outflow is greater than any inflows, then it’s likely you’ll run out of water sooner or later.
The point I’m trying to make is not that one metric is better than the other but rather that both metrics measure different things and I’m not certain that one must come before the other.
Seedly has a set of 8 personal finance metrics which I like. They range from measuring solvency to the proportion of non-housing assets to net worth. I’ve adapted some of these and added levels against which you can measure your progress. This is very raw but I think it’s something worth exploring and refining.
More importantly, I hope it’ll be useful in helping people figure out how far along they are in terms of financial independence or it could also be used as a measure of financial fitness (i.e. which areas of your personal finances are you stronger or weaker in)
Measuring financial fitness
Here are some metrics I think are useful and the various levels to assess one’s fitness.
| Levels | Savings rate (with CPF) (%) | Savings rate (w/o CPF) (%) | Debt servicing ratio | Debt to equity (%) | Months of emergency cash | Net worth | Liquid assets (% of net worth) | Income from assets (% of current expenses) |
| 1 | < mandated CPF contribution rates | < 0% | Unable to repay periodic payments | >100 | Nil | <0 | Nil | Nil |
| 2 | = mandated CPF contribution rates | = 0 | Able to only make min. repayments to rollover debt | =100 | < 3 | 0 | 0-15 | 0-30 |
| 3 | < mandated CPF contribution rates + 10% | 1-10 | Able to repay debt repayments | <=60 | < 6 | >=$100K | 16-30 | >30 |
| 4 | < mandated CPF contribution rates + 20% | 20-30 | Monthly income > 5x monthly debt repayments | <=40 | < 10 | >=$1M | 31-45 | >50 |
| 5 | < mandated CPF contribution rates + 30% | >30 | Monthly income > 10x monthly debt repayments | <=20 | > 12 | >=$5M | >45 | >100 |
Let me describe each measure, how it’s calculated, and why it matters.
Savings rate (with CPF) – this measures the total amount saved either through CPF or net monthly pay. While many people in Singapore use their CPF OA to pay for their monthly mortgage, this metric gives a more comprehensive picture of a person’s true savings rate since it is not true that ALL Singaporeans will use their CPF OA money for housing.
Savings rates (w/o CPF) – this measures the savings rate based on net monthly income. It indicates one’s willingness and/or ability to forgo current consumption and is a good indicator of how soon a person can reach financial independence. This is especially so since there is a cap on CPF contributions above a certain income. From the earlier piece on retirement, it appears that a savings rate of 10% is typical across the developed world, hence I’ve let 10% be the middle ground (i.e. Level 3).
Debt servicing ratio – this is a cashflow measure that determines whether one is on the road to financial ruin. After all, if one’s income is unable to (fully) service their debt, then interest on the debt will accumulate and you will either need to sell assets to raise cash or find other sources of credit to draw from.
Debt to equity – provides an indication of one’s ability to take on and service debt. In this case, equity for a person is equivalent to his/her net worth. It’s an indicator of their ability to pay off their debts. Any number above 100% means that a person is technically insolvent because the equity (assuming it’s sold instantaneously for its current value) is not even able to cover the amount of debt that one has.
Months of emergency cash – An indicator of how much cash a person has to tide through any loss of income. Depending on how conservative you want to be and assuming the typical case where income is more than expenses, you could measure this as months of expenses to cover (less conservative) or months of income to cover (more conservative).
Net worth – everyone’s favourite indicator. More often used in a dick-swinging contest but it gives a person an indication of how wealthy you are and how many goods or services you could theoretically purchase. Obviously, the higher the number, the better. I’ve used $5M as the entry point for the highest level because let’s face it, inflation has and will continue to make being a millionaire less of a deal than it used to be.
Liquid assets – an indicator of true wealth since liquid assets are also assets that are more likely to be liquidated close to their stated value at any point in time. Classification by their broad category can be misleading. For example, equities are generally thought to be liquid assets but some equities can be thinly traded and have large bid-ask spreads, making their net realisable value quite different from the current value. Markets that are liquid may also see their liquidity vanish in certain scenarios. Generally, the higher the better and it’s quite telling that as people get richer, they tend to hold a larger proportion of their net worth in financial assets (liquid) rather than real estate (less liquid).
Income from assets – An indicator of whether you still need that income from work. These include income from fixed-income instruments, dividends from equities, or rental income from real estate. Putting Dividend Irrelevance aside, many retirees and investors spend only their dividends and don’t draw down on the principal. You may argue that this is not optimal but if it works from a behavioural standpoint, then it is what it is. In general, the higher the better as this reduces the need for an income from work.
In short, the above metrics seek to measure a person’s ability to withstand financial hardship in the event of loss of income from work or to meet unexpected expenses. It also looks at whether a person has difficulty repaying debts or risks becoming bankrupt.
Where I stand on financial fitness
| Savings rate (with CPF) (%) | Savings rate (w/o CPF) (%) | Debt servicing ratio | Debt to equity (%) | Months of emergency cash | Net worth | Liquid assets (% of net worth) | Income from assets (% of current expenses) |
| 46% | 21% | 4x | 11% | 11 | >=$1M | 39% | 13% |
As you can see, I’m at level 4 on most measures which is to say that financially, I’m in a comfortable spot. While my debt servicing ratio is at level 3 (it’s probably closer to level 4), I wouldn’t worry too much because my debt-to-equity levels are really low (level 5).
The area that I really need to work on is increasing my income from assets (level 2). This is an indication that a good proportion of my assets are non-income producing (i.e. home equity, non-dividend paying stocks/businesses, or capital gains from past investments).
I’ll be tracking these metrics on a monthly basis to see how they evolve. I don’t expect to see much change from month to month but I guess it’s like monitoring things such as blood pressure to make sure that everything’s going well.
I’m sure there are many ways to improve these metrics. Maybe we could measure net worth excluding primary residence?[1] Are there other metrics to consider? Are the various levels appropriate?
Let me know what you think in the comments below!
Notes:
[1] Although the counter-argument is that for someone who’s considering selling their house to live overseas or to rent out their house and rent overseas, including their primary residence in the calculation gives a more economically-accurate picture of their finances.
Ryan Goh: Life through these eyes 