In today's fast-paced world, managing personal finances can be a challenging task. Whether you are seeking professional guidance or prefer a do-it-yourself approach, understanding your financial situation is crucial. One effective way to gain insights into your financial strengths and weaknesses is by utilizing financial ratios. These ratios provide a quantitative analysis of your financial health and can guide you in making informed decisions regarding the different aspects of your personal finances. In this article, we will explore six common financial ratios that can help you evaluate your current financial standing and create a solid foundation for financial well-being.
1. Emergency Fund Ratio:
Having an emergency fund is a vital component of financial stability. It acts as a safety net, providing you with readily available funds in case of unexpected events such as job loss or other emergencies. The emergency fund ratio measures the number of months your cash savings can cover your monthly non-discretionary (unavoidable) expenses. The idea is simply how many months can you continue to live comfortably in absence of any income.
To calculate this ratio, divide your cash/liquid savings or investments by your monthly non-discretionary expenses, which include utility bills, rent, educational fees, EMIs and other household expenses. Financial experts generally recommend maintaining an emergency fund equivalent to at least three to six months of these expenses. The higher the emergency fund ratio, the better prepared you are to handle unforeseen circumstances.
2. Savings Ratio:
Saving and investing the money for the future financial goals is a very crucial aspect of personal finance. Your savings ratio represents the portion of your income that you save and invest aside for your financial or life goals like retirement, education for child, purchase of home /car and so on. It is generally recommended to save at least 10% and 15% of your income each month to build a healthy savings cushion. However, the ideal savings rate may vary depending on your specific goals and age and the amount of savings you can manage. When one is young, the income can be less and expenses /liabilities more since you are in the consumption phase and thus the savings can be less. However, when you are accumulating phase of your life, with higher income you should aim for as much as you can possible manage. Evaluating your savings rate regularly can help you stay on track and make adjustments as needed. By prioritizing savings and managing expenses effectively, you can build a strong financial foundation for the future.
3. Debt to Total Assets Ratio:
The debt to total assets ratio provides insight into the portion of your assets that your lenders own. These debts would include your home loan, car loans, personal loans, credit card outstandings and so on. As you repay these debts your ratio decreases. This ratio is typically high in younger individuals and gradually declines with age as one builds assets and pays off debt. A lower debt-to-total assets ratio indicates a healthier financial situation, especially as you approach retirement. This can be also a good indicator of personal financial well-being and the debt burden on the lines of the Debt to Equity ratio for companies that research analysts track. The ratio is calculated as your total debt divided by your total assets. The aim should be to have a lower ratio here and is indicative that the debt burden is less.
4. Net Worth to Total Assets Ratio:
Your net worth is the difference between your assets and liabilities. It represents the value of what you own after deducting what you owe. The net worth to total assets ratio, also known as the solvency ratio, measures the percentage of your total assets that you own. Tracking this ratio over time allows you to monitor your wealth accumulation and provides motivation during debt repayment. This is similar to the earlier ratio but the perspective is different as we are evaluating your actual networth here and not the debt against total assets.
Younger individuals commonly have a net worth to total assets ratio of around 20%, while individuals in retirement should aim for a ratio closer to 90% to 100%. Achieving a higher ratio indicates significant progress in eliminating debts and building wealth.
5. Liquidity of Portfolio
The liquidity of your portfolio refers to the proportion of your total net worth held in liquid and disposable assets. This ratio depends on your financial goals and should be evaluated accordingly. If you have short-term goals or goals nearing maturity, a higher proportion of liquid assets is recommended. Quite often we have seen that the wealth or net-worth is locked in assets such as land, property, gold and so on which cannot be disposed off in times of emergency. Further, for properties used for consumption, like residence, there is some debate as to whether it should be considered at all when calculating this ratio.
To assess the liquidity of your portfolio, divide your liquid assets by your total net worth. It is essential to strike a balance between financial and non-financial assets or liquid and illiquid assets, considering your specific financial objectives. There have been many cases where people have suffered and had to borrow money even though they had sizable money locked up in illiquid assets.
6. Debt Servicing Ratio:
The Debt Servicing Ratio is a measure of your ability to repay your debt obligations. It is calculated by dividing the monthly debt payments by the monthly income. A good Debt Servicing Ratio is generally considered to be one-third or less. This means that your monthly debt payments, like your EMIs, should not ideally exceed a third of your monthly income. A higher ratio indicates that there exists the risk of financial problems, as one may have difficulty in making debt payments. A higher ratio also means that not enough is left for savings and for meeting discretionary and non-discretionary household expenses. However, the ideal ratio is subjective and will change with time and usually would be higher when one is young and falls when one has higher income levels.
Conclusion:
In brief, understanding and utilizing personal finance ratios can provide valuable insights into your financial situation and guide you in making informed decisions. By regularly monitoring these ratios and making necessary adjustments, you can create a solid financial plan to achieve your goals. Whether you decide to seek professional advice or take a DIY (Do-It-Yourself) approach, these ratios will help you gain a better understanding of your financial health and focus on areas that require attention. Start evaluating your personal finance ratios today and pave the way for a brighter financial future.
