Examining a Model of Economic Well-Being Based on Financial Ratios

Park, Mi jung, DeVaney, Sharon A., Consumer Interests Annual

The purpose of this study was to examine a model of economic well-being based on the debt-to-income and debt-to-assets ratios. It was proposed that socioeconomic, attitudinal, and behavioral factors would affect whether households had satisfactory values for the debt-to-income and debt-to-assets ratios. The results of logistic regression with 4,519 households in the 2004 Survey of Consumer Finances showed that single female households were more likely than couples to have satisfactory debt/income (D/I) ratio values but less likely than couples to have satisfactory debt/asset (D/A) ratio values. There was no difference between single male households and couple households for either ratio.

Introduction

The term well-being has been used interchangeably with happiness or having a worthwhile life (Diener, 1984). A key component of overall well-being is economic well-being or access to economic resources (Osberg & Sharpe, 2002). There are many indicators of economic well-being. For example, Osberg and Sharpe used consumption flows, accumulation of stocks, economic security, and income distribution to measure economic wellbeing. Zedlewski (2000) criticized the measurement of family's economic well-being and suggested that employment, poverty, food affordability, and housing affordability should be included when discussing well-being. Nevertheless, the most frequently used financial indicators of economic well-being are households' income, assets, and debt.

Income is usually the primary indicator of economic well-being; it also has a relationship with psychological well-being (Campbell, 1976). However, income by itself is not an adequate measure of well-being because it might not fully represent all of the components of economic resources (Mullis, 1992). Assets are more comprehensive than income which means that they, too, should be a good indicator of well-being. It is also important to consider the level of debt that a household has because this can indicate whether it is at risk of overspending. To integrate these indicators (income, assets, and debt), financial ratios are commonly used.

A financial ratio is an index that can be used to measure current financial strength as well as progress over time (Winger & Frasca, 2000). For example, the debt-to-assets ratio can be used to assess household solvency and also the ability to pay debts. For instance, Zhang and DeVaney (1999) found that households having a higher debt-to-assets ratio were more likely to have debt payment difficulties.

Another perspective on economic well-being is to include the composition of the household. Does the household consist of a couple or a single individual? Additional insight could be obtained by considering whether the single individual is a man or a woman. Previous research supports this conceptual model of considering the composition of the household.

Sunden and Surette (1998) concluded that gender and marital status significantly affected an individual's preference in allocating assets. Smyth and Weston (2000) found that women and children were more likely than men to experience financial hardship after divorce. Sobieszczyk, Knodel and Chayovan (2003) showed that marital status often mediates gender differences in well-being among older people.

Therefore, the purpose of this study is to examine a model of economic well-being. The study will differ from previous research on economic well-being because it will use two financial ratios to evaluate economic wellbeing. In addition, the study will consider if economic well-being is different for couples and single male or single female households. The results should contribute to an increased understanding of economic well-being by educators, researchers, and policy makers.

Review of Literature

The Use of Financial Ratios

Financial ratios have been used as guidelines in personal financial planning and to predict household insolvency (Baek & DeVaney, 2004; DeVaney, 2000; Garman & Forgue, 1994). In this study, two ratios, debt-to-income and debt-to-assets, will be used to examine economic well-being. The debt-to-income ratio reveals the proportion of gross income used to repay consumer debt. Home mortgage debt is usually excluded from consumer debt because a mortgage is perceived as an investment which is in contrast to most consumer goods (DeVaney, 2000). The debt-to-income ratio represents how much debt a household can safely manage in relationship to the amount of income (Sullivan, Warren & Westbrook, 2000). Most experts recommend debt-to-income ratios of less than 15 percent (DeVaney, 2000; Garman & Forgue, 2006).

The debt-to-assets ratio assesses households' solvency and ability to pay their debts. Many studies have used debt-to-assets ratios to measure financial wellness (Baeck & DeVaney, 2003; Baek & DeVaney, 2004) If total debts exceed total assets, the household is technically insolvent. An excessive use of debt might result in bankruptcy. Thus, the smaller the debt-to-assets ratio, the better. In general, a debt-to-assets ratio below 0.5 is recommended (Winger & Frasca, 2000). This ratio value means that debts should be less than one half the value of assets. In this study, a satisfactory level of debt-to-income and debt-to-assets will be defined as D/I ratio value less than 0.15 and D/A ratio value less than 0.5 (DeVaney, 2000; Winger and Frasca, 2000).

Marital Status, Gender and Household Size

Previous research has shown the effect of marital status, gender, and household size on economic wellbeing. Browning and Lusardi (1996) showed that marital status and household size influenced the household's consumption and savings behavior. DeVaney, Chiremba, and Vincent (2004) found that housing cost burden was greater for single women compared to couples. Lyons and Yilmazer (2004) showed that women who were married to less educated and older men were less likely to take risk with their investments. Titus, Fanslow, and Hira (1989) found that household size was negatively related to net worth. Godwin (1998) showed that household size was positively related to the amount of debt. Based on the previous studies, the following hypotheses were proposed.

H1a: Compared to couples, single women and single men will be less likely to have satisfactory D/I ratio values.

H1b: Compared to couples, single women and single men will be less likely to have satisfactory D/A ratio values.

H2a: Compared to households without children, those households who have dependent children will be less likely to have satisfactory D/I ratio values.

H2b: Compared to households without children, those households who have dependent children will be less likely to have satisfactory D/A ratio values.

Age

Age is an indicator of future earning potential as the slope of the age-earnings profile changes over the average person's working life (Munnell, Tootell, Browne, & McEneaney, 1996). Titus et al. (1989) showed that age and income were positively related to net worth. Household headed by individuals who were younger, unmarried, and with more children were more likely to have difficulty in repaying debt on time (Zhang & DeVaney, 1999). Therefore, the relationship between age and debt-to-income and debt-to-assets was proposed as follows:

H3a: As age of the household head increases, the household will be more likely to have satisfactory D/I ratio values.

H3b: As age of the household head increases, the household will be more likely to have satisfactory D/A ratio values.

Human Capital

Measures of human capital such as education level and employment are important predictors of savings and debt (Baek & DeVaney, 2004; Godwin, 1998). Education level is usually positively related to economic well-being. Education level and marital status were shown to have a positive relationship with income stability (Sullivan & Fisher, 1998). Those who have more education are more likely to take risk when making investments and this is expected to increase economic well-being (Chang, DeVaney, & Chiremba, 2004; Chen & DeVaney, 2002; Grable & Lytton, 1998). Thus, the following hypotheses were proposed.

H4a: Household heads with more education will be more likely to have satisfactory D/I ratio values compared to heads with less education.

H4b: Household heads with more education will be more likely to have satisfactory D/A ratio values compared to heads with less education.

Baek and DeVaney (2004) …

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Publication information: Article title: Examining a Model of Economic Well-Being Based on Financial Ratios. Contributors: Park, Mi jung - Author, DeVaney, Sharon A. - Author. Magazine title: Consumer Interests Annual. Volume: 53. Publication date: Annual 2007. Page number: 131+. © 2007 American Council on Consumer Interests. COPYRIGHT 2007 Gale Group.

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