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Financial Ratios: Quick way to check your fiscal health

InvestmentYogi: Leading personal finance site tells you all about personal financial ratios and how to do your financial health check

                                

“Prevention is better than cure”. You need to assess your fiscal health and take remedial action before it’s too late. personal financial ratiosFinancial ratios are decision making tools which tell you how good or bad your financial health is. Since this financial year is about to end you should sit down and spend some time on it. We present some useful and easy to calculate personal finance ratios.

     

Why are they relevant?

Personal financial ratios are devices used to better understand your financial standing. They also attempt to make impending financial crisis visible, which we might have otherwise overlooked. For example, a growing credit card debt may be creeping up on you; soon to become a burden. Debt to income ratio will make the growing debt burden visible.

 

There is a fundamental relationship between one's monthly income, debt (debt is synonymous with liability), and savings - one affects the other and so on. Individuals need to act fast before the situation becomes unmanageable.

    

Below is a list of most important personal financial ratios:

Before you start working on ratio analysis, the most important thing you need to ask is ‘what am I trying to find out?’ Once you have decided what you want to know then you can decide which ratio you need to use to analyze the problem facing you.

  

1) Net Worth ratio

Simply put, it means if you were put on sale, how much you would be worth in rupee terms. Finding out your Net worth is the first step to your future financial goals’ journey. Before you can reach a financial goal, you need to know where you currently stand.

     

Net worth is not only that starting step that directs you to set a financial plan to reach your goals, but helps you to protect your assets via insurance coverage by determining the worth of your assets.

Formula: Net Worth = Total of all your assets – Total of all your liabilities

Thumb rule: Net Worth thumb rule = (Your Age x Gross Annual Income from all sources except inheritances)/10*;

   

Example: If you're 30 and earn Rs 5 lakhs a year, ideally you should have a net worth equal to or more than Rs 15 lakhs.

  

2 more net worth ratios -

(i) Total Debt-to-Net Worth: This ratio compares your overall debt to your wealth.

Formula: Total of all Liabilities / Net Worth

Thumb rule: Total debt-to-net worth ratio should be kept below 1.

      

(ii) Liquid assets to Net worth ratio: It indicates that the liquid part of your net worth is an emergency fund and for what period would it support you. Liquidity is required for sudden short-term contingencies (and/or opportunities!). Remember to always keep enough cash on hand (preferably in a liquid mutual fund) for 6 months worth of expenses.

  

Formula: Liquidity to Net Worth ratio = Liquid Assets (including financial assets such a stocks, mutual funds, bonds, cash)/Net Worth

Rule of thumb: Around 15% is a sign of good liquidity. Above it can be excess liquidity meaning the person is losing out on investment opportunities.

  

2) Savings ratio

percentage The Savings ratio simply tells you how much are you saving monthly. It is not only the proportion of income which is saved, but also a measure of one's risk profile­ whether you are proactive with investments or not.

Formula: Savings Ratio = Monthly savings / Total monthly Income

Rule of thumb: There is no general rule of thumb as the amount of savings to be made depends upon an individual’s lifecycle stage. As a guideline, it can be taken as 15%-20% of monthly salary. However, the more the better.

         

Note: A single month savings ratio does not reveal much but taking an average of several monthly savings ratios will be a better indicator of how good or bad you are at saving.

   

3) Debt to income ratio

This ratio indicates the total monthly income that goes towards paying all your monthly debts (home loan, car loan, personal loan, credit card, consumer durable, gold loan etc) - all outflows towards servicing debt are taken into account here.

Formula: Debt to Income Ratio = Monthly debt payments / Total monthly Income

 

But just about everyone has debt. The real question how much is too much? That will again depend upon the lifecycle stage of the individual. For example, a man in his early 30s usually would be servicing more debt payments (on account of home loan, auto loan, consumer durable etc) than a person in his 50s who is nearing retirement.

    

Rule of Thumb: The lower the ratio, the better. The lower this ratio the lesser burden there is on the individual to make payments on his/her debts. High debt to income ratio also means having a low savings rates. It also threatens one’s ability to retire with the desired retirement corpus.  General guideline is a ratio of less than 40%.

      

2 more Debt ratios:

(i) Housing loan outflow Ratio – This is a parallel version of debt-income ratio used by home loan underwriters to scrutinize the creditworthiness of borrowers. You can apply this to assess your monthly housing loan liability against monthly total income.

Formula: (Home loan EMI + loan insurance + property taxes + other relevant payments) / by Total Monthly Income

Rule of Thumb: Housing loan expenses should not exceed 30% of gross monthly income.

    

(ii) Credit card debt Ratio – On similar lines of housing loan outflow ratio is credit card debt ratio. It is useful to assess credit card debt payments vis a vis total monthly income.

Formula: Monthly credit card debt payments/ Total monthly income

Rule of Thumb: This ratio should be less than 20%. A high ratio could point to excessive use of credit cards.

  

4) Debt assets to Total assets ratio

This ratio compares total debt assets to total assets to gain a general idea as to the amount of borrowed money being used by you.

Formula: Total debt assets/Total assets

Rule of thumb: A lower ratio is desirable. A low ratio means that you are less dependent on borrowed money.

         

An Illustration

calculator Let's take a look at some of the particulars from the financial statement of Mr Naresh, 34, Marketing manager at a retail chain:

  1. Gross monthly salary: Rs 1,00,000 pm
  2. Home Loan EMI: Rs 30,000 pm; Amount outstanding: Rs 45,78,900
  3. Car Loan EMI: Rs 10,000 pm.; Amount outstanding: Rs 5,03,000
  4. Credit card outstanding: Rs 5,000 (for month ending Jan, 2010)
  5. Monthly Savings: Rs 50,000 pm
  6. Current value of Investments (Equities): Rs 8,00.000
  7. Residential property: Rs 52,00,000
  8. Provident Fund balance: Rs 1,02,000

     

Based on this information, the individual ratios are as follows:

    

  • Net Worth: 61,02,000 – 50,86,900 = Rs 10,15,100
  • Total Debt to Net Worth ratio: 50,86,900/10,15,100 = 500%
  • Liquid assets to Net Worth ratio: 8,00,000/10,15,100 = 79%
  • Savings ratio: 50,000/1,00,000 = 50%
  • Debt to income ratio: (3,00,00 + 10,000 + 5,000) / 1,00,000 = 45%
  • Housing loan outflow ratio: 30,000 / 1,00,000 = 30%
  • Credit card debt ratio: 5,000 / 1,00,000 = 5%
  • Debt assets to Total assets ratio: 10,2000 / 6,10,2000 = 1.67%

  

Analysis –From the above ratios, we see that although his savings rate is good for his age, debt is high and needs to be trimmed – he may do it by prepaying his car loan (which gives no tax benefits) with a combination of surplus savings lying in his bank account, windfall gains from equities, etc. He has surplus liquidity to counter any short-term unforeseen circumstances. Also, debt assets to total assets ratio is low at 1.67%, which means that his assets are not well diversified and he lacks safety/security factor in his investments. The housing loan outflow ratio and credit card debt ratio are within the thumb rule of 30% and 20% respectively. If Naresh reduces his debt (by foreclosing auto loan), he may divert the extra cash towards paying down his home loan or make investments towards retirement plan or other future aspirations.

  

Before concluding, the following points may be noted –

  1. Ratios serve as a quick guideline to help individuals assess their current financial health.
  2. There may be different ways to compute ratios. It is important to be consistent and use the same method when making comparisons.
  3. Ratios maybe calculated over time so that trends can be seen. Setting up an Excel worksheet is helpful - you can create a table containing a list of your ratios – month-by-month/year-by-year; this will help you organize & see trends.
  4. Financial ratios need to be considered in the context of your personal situation. Therefore, life cycle is an important factor to consider as you review your financial ratios. Moreover, Ratio analysis alone cannot be used to draw a financial plan as they cannot be a substitute for experience and guidance. You should consult a qualified financial planner when in doubt. 

   

Conclusion:

The objective of the personal financial ratios is to help individuals move from a situation of having low net worth, high debt and low savings to one where they have high net worth, low debt and high savings. The rule of thumb given for the each ratio is on a generalized basis to facilitate individuals to use them as a benchmark to improve their financial situation. The more people understand these primary principles, the more likely it is they will make good financial decisions.

     

Action item:

InvestmentYogi has created an application (free online financial plan) which calculates all these ratios for you. It takes only a few minutes of time. Click at this link and start with the FREE basic plan : http://investmentyogi.com/Financialplans/common/home.aspx 

       

*[source: The Millionaire Next Door by Thomas J. Stanley].

Published Feb 21 2010


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Comments

Comments

 

Trader Anup said:

Nice article on applying the concepts of financial ratios from accounting to personal finance.

February 22, 2010 8:51 AM
 

Abhinav said:

Good article....better understood by anyone and everyone.

March 18, 2010 1:24 AM
 

Selvam said:

Very knowledgeable article on wealth Ratios,  if we take this practically and apply to our own financial lives we will know where we are, lets do a self test and analyse where  we are today and gear ourselves for better financial future.

Edwin Selvam

April 24, 2010 3:06 AM
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