by Craig Swanson, Investment Management, Wealth Enhancement Group

Financial flexibility equals financial freedom. Businesses look at financial flexibility as an important measure of financial freedom. If a business is financially flexible it has the freedom to take advantage of future opportunities, rather than being handcuffed by financial obligations. Individuals and families can also measure their financial freedom by looking at their financial flexibility.

Simply put, being financially flexible means having financial resources available when an opportunity or need arises. One way corporate finance analysts measure this is to compare the net operating income of the business to the debt payments due each period. Depending on the nature of the business, they want to have enough operating income to cover their debt payments with varying degrees of room to spare. That way, if an unexpected hardship arises, there will be enough cash coming in to pay their obligations while management works to strengthen the firm. Typically, riskier businesses would want a higher ratio, such as operating earnings equal to three times the level of debt payments, while a stable, dependable business would be satisfied with a lower ratio, such as 1.2 times the amount of debt payments.

A similar comparison can also be done by individuals with their personal financial statements. You probably have some sense of how flexible your finances are simply by looking at your bank balances, but for many people, putting a number behind it often adds clarity and provides a more tangible goal. If nothing else, the exercise can be another opportunity to review your financial liabilities and find ways to pare expenses. The mathematics of the ratio is pretty simple: compare your income to your financial obligations. The financial obligations in question are those to which you have a contractual commitment, such as a minimum credit card payment, a car payment, rent, utilities, and so forth. Including your contribution to savings in your obligations total will help to structure the healthiest financial arrangement.

The next important step is to decide what ratio you are comfortable with. It will vary based on circumstances such as your stage of life and how conservative you are. As an example, a 40 year-old who is focused on accumulating savings might target a ratio of around 2.8 or higher, a number roughly equivalent to what a loan officer might request for a mortgage buyer. Notice that this ratio is on par with that of "riskier" firms. The reasoning is that, for most people, income is derived from relatively few sources, such as a paycheck for those still in their working years. Such undiversified sources of income are inherently risky and should be considered as such in prudent planning.

Compare your current ratio to your target ratio and manage your finances to achieve this goal. Obviously, it is only one of many important considerations, but you can use the information to help guide purchases. For example, if you are considering buying a new boat, but it would put your ratio below your target, you can then try to come up with alternatives, such as waiting to pay off another debt before buying the boat. Ideally, you should be able to pay your savings accounts, pay your debt, have some fun and still be better off than you were the previous month.