Fundamental ratios are important for investors to judge the health of companies. They tell us the importance of one figure in relation to other. For individuals too, there are financial ratios that help maintain individuals’ financial health as well as provide guidelines for financial prudence in dealing with credit, expenses, risk, and liquidity.
Just like fundamental ratios indicate the financial health of companies at a point in time, personal finance ratios do the same for individuals. Let’s look at some of the ratios that individuals should track to ensure they do not end up in financial distress. We will discuss 5 most important personal finance ratios.
Just like current and quick ratio in case of companies, liquidity ratio is of two types for individuals –
Basic Liquidity Ratio
Basic liquidity ratio measures the cash and cash equivalents (such as current account, savings account, and gold, and flexible deposits account) with respect to your monthly expenses. The idea is to find out how many months you can survive without earning. Gold, even though very liquid, may not be counted under cash and cash equivalents. Hence if you have 10 lakhs in bank deposits and your monthly expense is 50,000, your basic liquidity ratio is 20. Typically, this ratio should be at least 6.
Expanded liquidity ratio
This includes other investments which can be liquidated but there could be chance of losses. Suppose an individual has 10 lakhs in bank deposits and 10 lakhs in stocks, his expanded liquidity ratio will be 40.
Debt to Income Ratio
In today’s world, where buying credit is rampant, it is important to limit your debt. Debt ratio measures the debt obligation to your monthly income. In other words, what is the size of your EMI with respect to your monthly income?
Individuals should not let their total debt obligation exceed 40% of their income. Today, the situation is different though. The debt income ratio for many individuals has gone up to a dangerous level. Increasing interest rates have only added to the deterioration of this ratio. Increasing debt obligation exerts a price on individuals’ lifestyle.
Risk Exposure Ratio
Risk exposure ratio tells you the number of years your family can survive in case of any eventuality. This is calculated by dividing your asset base and insurance cover with the yearly expenses of your family.
Suppose a person has an insurance cover of 40 lakhs and has an asset base of 60 lakhs. His family expense per year is 10,00,000 per annum. This means his family can survive 10 years without getting any extra money. We are assuming here that inflation can be easily compensated by the returns this asset base will generate. Moreover, the actual expenses may even be less. Risk exposure ratio can be used for individuals to decide the right insurance for his or her family.
Savings to Income Ratio
This is one of the most important ratios. This ratio shows the soundness of your finances. A high saving rate enables you to face any unanticipated needs. Fortunately, this ratio is good for most of the Indians but recent trend shows increasing trend of living on credit.
To calculate saving to income ratio, divide your average monthly savings with monthly income. The ideal ratio depends on age of the individual. A newly employed person should be able to save 30%-50% of his or her income. Similarly, senior professionals should have high percentage of savings to income ratio.
Personal net worth
Personal net worth is nothing but your assets minus the liabilities. Net worth shows the financial status of individuals. While net worth is important, growth of it is as important.
For example, if an individual has 20 lakhs invested in Gold, 50 lakhs in property, and 30 lakhs in stocks, his asset is 100 lakhs. If he has outstanding loan of 40 lakhs, his net worth will be 100 – 40 = 60 lakhs. Whether this number is adequate depends on the age of the individual, size of the family, and rate of growth of net worth. The rate should be more than inflation, higher, the better. If your net worth is growing at a lower rate than the inflation, you are actually losing value of your net worth.
Financial ratios are important for individuals too. It gives you tools to assess, analyze, and take remedial measures to improve your financial status. Individuals and families should use these ratios and define a benchmark to be followed religiously.
The author Pankaj Priyadarshi is a financial consultant and can be reached at firstname.lastname@example.org. He is B.Tech from IIT, Kharagpur and MBA from ISB, Hyderabad.