When making complicated financial decisions, you must take into account a critical factor; the personal financial ratios.
Now, why do I suggest that? You might wonder.
The answer is simple.
You need to be fully conscious of your financial fitness before allocating your valuable resources in various investment areas and making wise financial decisions that can potentially define your whole future.
And the way to do that is by understanding your personal financial ratios!
These ratios are like tools drawn to understand and evaluate your financial strengths and weaknesses.
If you want to take a reliable and smart step regarding your finances, you need to be updated with the healthy personal financial ratios, and that’s what this post is all about!
To make it easier to comprehend and differentiate, we have divided the personal financial ratios into five broad categories.
Let us simplify them for you one by one.
In the simplest words, liquidity means how easily an asset or security can be converted into cash without having any effect on its market value.
Monetary assets are considered the most liquid assets.
Among these assets are cash, savings bonds, savings, and checking accounts which are enough to support your fixed monthly expenses for 3-6 months at least.
An emergency event can hit you any time, to make sure you can withstand it, it is highly recommended to have some of your assets in the form of cash, or ones that can be easily converted into cash.
We have two healthy ratios for this purpose.
Basic Liquidity Ratio
The formula goes as follows:
Basic Liquidity Ratio: Monetary Assets/ Monthly Expenses
This ratio gives you a simple expression in terms of time (months) to check whether you have adequate cash to meet your monthly expenses conveniently.
A healthy value is between 3-6 months of enough cash reserve but for unemployed or an elderly (above 40) person, cash reserve for up to 1 year is recommended to compensate for the time of job hunting.
Let’s see it through an example.
Imagine your monthly expenses to be around $8,000.
And you have the following assets:
Savings Account: $12,000
Checking account: $5000
Invested in stocks: $20,000
Invested in Bonds: $15,000
$10,000 from your investment in stocks and bonds are maturing in one day.
So, for how many months can you easily cover your expenses with the liquid assets?
Let’s find out:
Monetary Assets: $12,000 + $5000 + $10,000 = $27,000
Monthly Expenses: $8,000
Basic Liquidity Ratio: 27,000/8,000 = 3.375
It means you have enough liquid assets to cover you up for almost three and a half months!
It is the minimum recommended value by financial experts, and you should work to improve it further.
You might have observed that we did not add the values invested in stocks and bonds.
This is because the stocks and bonds which are not maturing in a very short time are not monetary assets since they cannot be quickly converted into cash and carry significant market risks.
Liquid Assets to Net Worth Ratio
This ratio tells you what portion of your net worth is or should be liquid and is calculated by the following formula:
Liquid Assets to Net Worth Ratio = Liquid Assets / Net Worth
Let’s continue with the above example and consider your liquid assets to be a total of $27,000.
And assume your Net worth (Total assets – Total liabilities) to be around $65,000
After the calculations, your liquid assets to the net worth ratio (27,000/65,000) is 0.41.
According to the general rule of thumb by most financial advisors, a value of 20% is adequate.
Anything below 15% is a red alert.
Adequate savings is one of the most vital parts of your household goals and financial road.
Always give it utmost importance while sketching down your budget and make it a habit to pay yourself first!
You must strive hard to have 10% of your gross income to be saved for the sake of your financial freedom.
The personal finance savings ratio refers to the amount you must save for you to meet your future goals. Without cautiously drawing this ratio, you are as good as throwing your money in a fire and watching it burn.
This is how you can calculate your saving ratio:
Saving Ratio= Net Annual Savings/ Total Annual Income
Your net annual savings refers to the money you have put aside after conveniently meeting all your essential finances. It also points out the money in your bank accounts or your liquid funds.
Gross income simply means your total source of income as in what you earn, income from your profession or job, cash from any side business, and so on.
It is highly recommended for your saving ratio to be at least 10% of your Gross income, but as your financial status rises, you can increase it to up to 20%.
If that happens, then you are in a very comfortable position.
Hence, the saving ratio formula for personal finance can always make the picture clearer.
Moving forward, we have the Debt ratios which reflect a person’s borrowing position.
Whether or not you are in a position to borrow some more loans or whether you should patiently wait until you pay off the already hanging ones.
It would be best if you always tried to minimize your debt as much as possible to upturn your net worth and meet your financial goals faster.
We have two essential ratios to consider here.
Debt to Asset Ratio
Use this formula to calculate your debt to asset ratio for personal finance:
Debt to Asset Ratio= Total Liabilities/ Total Assets
When you talk about Liabilities, it generally refers to something you are responsible for or in other words; debt.
Your total liabilities refer to the personal loan, student loan, home loan, or any other loan you have in your hands. Whereas, assets are defined as your investments, funds, car, home, or any other valuable thing owned by you.
A maximum of 50% debt to asset ratio should be your limit. You must not exceed more; you don’t want to live your life, clearing debts all day long.
In fact, the lower, the better.
Hence, it is also known as a personal gearing ratio.
Debt Service Ratio
The debt servicing ratio is your debt to income ratio and is calculated by summing up all your debt amounts and dividing the value by your gross monthly income.
It is one of the recommended measures for your financial health check
The given formula calculates it:
Debt Service Ratio = Total Debt Repayments / Total Monthly Income
Let’s consider your gross monthly income to be $10,000
And the following are your monthly debts:
Car Loan: $350
Student Debt: $250
Credit Card: $200
Total debt: $2300
Your Debt service ratio is 2300/ 10,000 = 0.23
Now, is it a good debt-to-income ratio?
Most lenders recommend a ratio of 36% or less to be suitable for loan approval. Studies have shown that borrowers with a high debt service ratio (43% and above) find it hard to make approved mortgage payments on time.
I would suggest you keep your TDS Ratio even lower, say 25% to be always on a safe side.
Investment is your ultimate personal finance goal and if done smartly, a safe road to financial freedom.
Therefore, you should always be cognizant of your investments.
One way to do it by always checking what part of your wealth is invested in valued assets.
For this, always consider the following ratio.
Net Invested Assets to Net Worth Ratio
Invested assets to Net Worth Ratio is like a litmus test to see where you are standing with your investments.
The formula goes as follows:
Net Invested Assets to Net Worth Ratio: Total invested assets/ Net worth
Investments assets usually have very low liquidity, i.e. it takes time to turn them into cash, such as stocks, unit trust, and assets in the form of a property while others can be in the form of retirement assets like EPF.
In simple words, it is the percentage of your wealth that you have allocated to investments.
Rule of thumb dictates that you should have at least 50% of your assets in some form of investment assets.
The percentage should only get higher when you are getting closer to your retirement age so that you can retire peacefully.
But it is not always likely for everyone to follow the financial health tips laid by experts.
How much can you invest in liquid assets like stocks and mutual funds and how much can you afford to invest in illiquid assets depends mostly on your personal financial situation.
Checking your investment-to-net worth ratio at least once a year will help you make necessary adjustments to keep your net-worth in good shape.
Solvency is a vital measure of financial health.
It refers to the ability of an individual to meet his debts and fulfil his financial obligations.
The formula goes like this:
Solvency Ratio = Net Worth / Total Assets
It tells you whether you have enough assets to meet your liabilities. In case of an unforeseen event, it means whether you can pay off your existing debt with your current assets.
If your net worth is $65,000 and your total assets (including Stocks, Bonds, and property) is $100,000, your solvency ratio is:
Solvency ratio: 65,000/ 100,000 = 0.65
It is a good solvency ratio.
These best personal finance ratios will help you to plan your future safely and help you make intelligent decisions about your savings, spending, and investing.
The Liquidity, Solvency, and Saving ratios will inform you if you are ready to cope up with emergencies while the Debt ratios will clarify your borrowing position. With Investment ratios, you can always ensure that your Net worth is in good numbers.
Ultimately all of these ratios will assess your financial health and guarantee you a smooth drive towards financial freedom.
Leaving it on a powerful note by Karen Barmen,
“The power of ratios lies in the fact that the numbers in the financial statements by themselves don’t reveal the whole story.”
Let that sink in and calculate your personal financial ratios now!