Every market savvy person must be aware of the importance of fundamental and technical analysis for evaluating a company. Charts, graphs, and ratios are at the crux of such analysis. Financial ratios form an integral part of a company’s financial statement and help to compare the performance of various companies at different time periods. The ratios help investors to take correct investment decisions.
In the same way, if an individual wants to evaluate his/her personal financial situation, based on the financial statements, considering the net worth or cash flow, or whether he/she has over-borrowed or has good liquidity, it can be determined by calculating Personal Finance Ratios.
The components involved in deriving the appropriate ratios are discussed in detail below. Personal financial ratios, unlike corporate ratios, are pretty simple. These seven ratios can help evaluate your financial health.
Important Personal Finance Ratios
1) Liquidity ratio
- This ratio is the indicator of a person’s ability to meet his/her regular expenses in the event of a contingency or unforeseen circumstance.
- In other words, how many months will your money last for if all your sources of income stopped due to any unexpected circumstances?
- Basic Liquidity Ratio (BLR) can be used to determine how many month’s expenses are provided for in the form of liquid money i.e., cash or near-cash assets.
Liquidity ratio = Cash (near cash) / monthly expenses
Cash (near cash) comprises all liquid assets like, bank savings accounts, cash in hand, fixed deposits, Liquid mutual funds. Monthly expenses are your gross expenses that u spend on a monthly basis includes both discretionary as well as non-discretionary expenses.
The ratio helps a person to be aware of his/her financial liquidity. It’s important to maintain a fixed level of liquidity to ward off unexpected financial hardships.
Example : Mr Kuberan has Rs 30,000 as cash at home & Rs 55,000 in Savings a/c. His monthly expenses are around Rs 15,000. What is his Liquidity Ratio?
Liquidity ratio = (30000 + 55000) / 15000 = 5.66
What would be considered as an ideal Liquidity ratio? – Anything around 4 to 8 months can be considered to be good, which means you need to have at least 4 times your monthly income parked in cash/near cash assets as an contingency fund (emergency fund). The ideal ratio can vary across age groups & income profiles. If you have stable income, you may need a lower liquidity ratio.
2) Savings ratio
- This ratio reveals the amount a person should keep away as savings for his/her future goals.
Savings ratio= Savings / gross income
Gross income includes money earned from salary, or a business or profession, bonus, dividend, interest, royalty/rent and all forms of earnings.
Example : Mr Kuberan (35 years) has around Rs 20,00,000 as investments in mutual funds, fixed deposits, PPF, bonds etc., His annual salary is Rs 5 Lakhs. What is his Savings to Income Ratio as of now?
Savings Ratio = 20 Lakhs / 5 Lakhs = 4
One question that people often ask me is how much of my income should I be saving, the answer to which is there is no one ratio for all, it depends upon a persons age, his Income and financial life goals. Of-course the higher the Savings ratio the sooner you can reach your goals.
3) Debt to asset ratio
- It helps people to understand whether they have over-borrowed (or) are in some uncomfortable position i.e. they are facing solvency issues.
- Debt to asset ratio should be used while taking a new loan. If you have already borrowed beyond your repayment capacity, it’s advisable to not take a new loan. That will increase your liabilities. A better idea would be to wait until the time you square off your existing loans.
Debt to Asset ratio = Total liabilities / Total assets
Total liabilities includes common debts like car loan, home loan, or personal loan, credit card dues, money borrowed from private lenders etc.
Total assets include all that an individual owns. These include investments, cash, car, house, jewellery, land and property, computers etc. If you consider only ‘Liquid assets’ (like cash, savings a/c balance, deposits etc.,) in place of Total Assets, this ratio can be called as ‘Liquid Assets Coverage Ratio’.
The ideal debt to asset ratio can be maximum 50%. It is advisable not to have the debt (loans, credit cards) go beyond 50% of your total assets.
4) Debt servicing ratio
- In today’s world, we buy most products and services on credit. Payments are largely made by credit cards or post-dated cheques. But it’s important to control your debt.
- The debt servicing ratio measures your debt obligation against your monthly income. In other words, what is the ratio of your EMI to the income?
Debt servicing ratio = Short term liabilities (EMIs) / Total income
You must never let the total debt obligation cross 40% of your total income. But unfortunately, the situation is very different now. The ratio for most individuals living in urban areas, have touched dangerous levels. Besides, increased interest rates have further compounded the misery. Increased debts exert a price on an individual’s lifestyle.
You can also calculate total liabilities (outstanding loan amounts instead of EMIs) to total income to find out your ‘Debt to Income’ ratio.
Your objective should be to move from a situation of high debt (if any) and low savings to a situation of no debt and high savings as your age/income increases.
5) Inflation hedge ratio
Hedging inflation is a strategy which provides protection as and when the value of the currency plummets. An inflation hedge usually involves investing in assets that has an historical ROI (Return on Investment) of more than that of the inflation.
Saving instruments like FDs may seem to offer a safe returns. But once you factor in the inflation, you might actually be loosing your money. For instance, if you invest in an FD that offers 6% returns post tax, at a time if the inflation rate is 7%, then you are actually losing your buying power. Assets that are considered inflation hedge are usually self-fulfilling. Investors resort to them to get a real rate of return (i.e. A return in excess of inflation rate). Assets like Equity is widely accepted as an inflation hedge investment.
The ratio at which you should invest in Inflation edge assets (like shares or equity mutual funds) depends upon factors like your age, risk appetite and your financial life goals.
6) Solvency ratio
Simply put, the solvency ratio will help you know whether the assets in your portfolio are adequate to service your debts. As you progress in life, you acquire assets and use the debt to finance them. But in many cases, the amount of assets is less than that the amount of debt.
Solvency ratio = Net worth / Total Assets
The net worth of a person is the difference between his/her total assets and liabilities. The net worth is positive if the market value of assets is more than the liabilities. The assets in this case include all bonds, equities, fixed debts, mutual funds etc. Even the cash in your savings bank account and the money you have kept under the mattress should be considered.
If your total debt is Rs 50 lakh and the total assets are Rs 35 lakh, then your solvency ratio is negative 0.42 (or -42%). Solvency ratio of > or = 50 can be considered to be good.
7) Life insurance coverage ratio
- This ratio can give your an idea if you have an adequate amount of life insurance coverage or not.
Life insurance coverage ratio = (Networth + existing life cover) / Post-tax Salary
The net worth of a person is the difference between his/her total assets and liabilities (financial & physical assets minus your loans).
Example : Mr Kuberan has total assets worth Rs 50 Lakh (including house property, gold, bonds, shares etc.,) and has an outstanding home loan amount of Rs 25 Lakh. He has taken a Term insurance life cover of Rs 30 Lakh. He earns an annual salary of Rs 5 Lakh. What is his Life insurance coverage ratio?
Life insurance coverage ratio = ((50 Lakhs – 25 Lakhs) + 30 Lakhs) / 5 Lakhs = 11
The ratio of 11 indicates that Mr Kuberan has provided for his family 11 years worth of expenses. Kindly note that this ratio does not consider the Time value of money concept / inflation rate. (Read : What is Time Value of Money? & What is Inflation?)
To summarize it..
These important Personal Finance ratios help you to analyse your financial health. While they may not tell a complete story, these ratios provide a practical tool to analyse your personal finances and track the progress you are making towards financial independence. (Read : Are you on the right path to achieve your FINANCIAL FREEDOM?)
This article has been co-authored by Kishor Kumar & myself (Sreekanth).
KishorKumar Balpalli – does not sing like his namesake but believes that financial literacy and discipline is the key to one’s financial freedom, Kishor a Certified Financial Planner with over a decade of experience in personal financial planning is a strong proponent of centric client practices. Kishor Kumar is the founder and CEO of mymoneysage.in, which is a unique online money management Platform.
(Kindly note that Relakhs.com is not associated with mymoneysage.in. This post is for information purposes only. This is a guest post and NOT a sponsored one.)
(Image courtesy of renjith krishnan at FreeDigitalPhotos.net)