Source/Contribution by : NJ Publications
As families seek to improve their financial situation and develop plans for the future, a logical first step is to determine their present financial position. A common tool used to determine same is the net worth statement which is a personal balance sheet listing the assets and liabilities of the household, with total net worth being the difference between the two. However, there is a lot we can know about our portfolio than just this measure. We would encourage investors to do an annual assessment of their financial situation to understand the same and to also chalk out a plan for progress for the future. In this issue, we will talk about the wealth of information which can be gleaned from a personal financial statement than just the bottom line.
Usage:
Application of the ratio analysis technique to personal financial offers potential in expanding insight into specific strengths and weaknesses of a family's financial situation. The ratios are presented below with indications of how each ratio might be used to assess liquidity, solvency, or the general financial position of a particular investor/family. The information should provide more specific directions in assisting the client to develop financial goals. A ratio typically expresses a relationship between two or more data points /information /parts of the financial statement and provides a context in which to evaluate various aspects of the financial situation.
Key Ratios:
-
Emergency Funds - Liquid assets / monthly expenses: Liquid assets are those assets which can be easily sold/liquidated and quickly converted to cash without any loss of value. This ratio provides insight into the adequacy of liquid asset holdings to cover monthly expenses if the family experiences a sudden loss of income due to loss of income for any reason. This ratio may be modified to include financial assets which are not in ready liquid form but could be easily redeemed and converted in cash.
Financial experts typically suggest at least 3 to 6 months of coverage depending on the situation, assets covered, income stability, the number of dependents, and so on. The higher the ratio, the better it is for families.
-
Debt Exposure - Assets /total debt: This ratio examines the relationship between assets and the total debt obligation of the family. Please note that which assets to be included here is of primary concern. If you only include liquid assets, the ratio will indicate how easily you could close off and repay all your debt. However, you could also include all your redeemable financial assets in addition to liquid assets. In such a case, it would show a different picture of your debt ratio. Together these ratios help in determining whether the family has overextended itself or has maintained a debt level within reasonable limits given the family's level of assets.
Experts suggest that a ratio of say at least 10% (assets as % of the debt) and above should be comfortable when only liquid assets are considered. When total financial assets are considered, then 30% may be considered a minimum level to indicate a healthy financial situation. If you are only considering long-term asset creating debt like home loans, then again the ratio of 10% should be acceptable.
-
Net Debt Position - Total debt/ Net worth: Normally the debt position of a family is not evaluated unless the situation is extreme. This ratio expands our understanding in assessing the debt position of the family by relating total liabilities to total net worth value. Experts recommend that families should keep this measure below 1.0 or 100% meaning that that total debt should never be more than your total net worth. However, if a family has recently purchased a long-term debt, like home loan, this ratio may go a bit higher in initial years. During such times, you could exclude that home loan debt and other such asset-creating long term debt and look at the ratio again. Experts suggest that in such a case, your debt should not be more than 40% of your net worth.
-
Debt servicing ratio - Monthly debt liabilities / Net income: The debt servicing ratio measures how easily you can service your debt. In other words, it is the ratio of your EMI to the net income. You must never let the total debt obligation cross 40% of your net income. The less it is the better. The idea is that the rest of the 60% has to be adequately saved for consumption and savings. However, this ratio for most individuals living in urban areas may touch dangerous levels of even over 80%. Increase in EMIs compromises your lifestyle and your ability to secure a better future through savings. One should aim to move from a situation of high debt and low savings to a situation of no debt and high savings as your age/income increases.
-
Liquidity of Portfolio: Liquid Assets/Net Worth: This measures the proportion of total net worth held in liquid form. This type of net worth component ratio should be evaluated after considering the family's financial goals rather than as an objective standard. If the majority of the goals are of short term or near to maturity, then the proportion of liquid assets should be higher. However, if you are having long term goals not anywhere near to maturity, your assets should be held largely in non-liquid assets like say equities. The reason being that such assets will provide better returns than liquid assets. Thus, it is up to the financial advisor /family to ascertain the right/optimum portion of liquid assets in your net worth.
One can further modify this ratio to also include all financial assets in addition to liquid assets as part of the total net worth. This ratio would indicate if you are investing too much in non-liquid and financial assets like gold, property, etc. One may think of ensuring a good balance between financial and non-financial assets with more bias to the former.
-
Savings Ratio - Savings / Net income: This ratio is used to show you how much money you are saving over a specified period. It is strongly advised to have a savings rate of at least 10% to 20% of your net income. The higher the number, the better it should be. In times when you do not have any debt EMIs or other expenses, one should be shrewd enough to let this ratio grow as much at possible. The equation should be calculated as income (-) savings = expenses whenever you are planning your monthly budget. Making the most of your available cash-flow and directing it towards savings is very essential as times may change in future when savings may not be that easy.
Conclusion: While there may be many more ratios for understanding personal finance, the above ratios are the key ones that help you understand your portfolio construction, your security and your savings behaviour better. Do not just stop at looking at net worth or the current value of your investments. Go beyond, take some time out, at least a couple of hours every month to calculate and track the trend of your personal finance ratio. Believe us, it will do wonders to your knowledge and your financial situation.
