In school, one could make out how a student was performing in studies on the basis of grades. In the corporate world, your performance can be assessed by your promotions, salary rise among other things. Basic Health indicators are sugar level, pulse rate, blood pressure. How do you know whether you are doing well in your finances? You might be getting a good salary and leading a comfortable life. But does that mean you are financially fit. The price to earning ratio (PE) and dividend yield of a company are used to evaluate valuation of company. Similarly there are some ratios that can be used to assess your financial health –
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1. Liquidity Ratio (or emergency fund) – Liquidity ratio measures your ability to pay for expenses with cash in hand. It is calculated as –
(Cash + Bank Balance)/ (Monthly Living Expenses)
Typically you should have cash/ bank balance to pay for living expenses of about 3-6 months depending on marriage status, home loan etc. You should check this ratio when you are planning to quit your job or taking a new job with a start-up where financial and career risks might be higher.
2. Savings to Income Ratio – This ratio compares amount invested and the total income earned per month.
(Amount invested per month) /(Total Income per month)
Savings can be in the form of cash, bank balance, FDs, PPF, Shares, Mutual Funds, Bonds etc. Minimum 20%-30% of gross income should go towards savings on a monthly basis.
3. Debt Service Ratio – This ratio shows the ability of a person to pay the loan instalments on a regular basis. It is calculated as –
(All EMIs & other debt payments) / (Family Gross Monthly Income)
It shows how much percentage of your monthly income is used for servicing loans. You will have to manage your investments and expenses with the remaining amount. The lower this ratio the better your debt management skills. It is advised that debt servicing should not take up more than 40% of your income.
4. Solvency Ratio – This ratio compares a person’s total assets and total liabilities to find if the person has the ability to pay off his debts.
(Financial Assets) / (Total Liabilities)
The ideal ratio depends on age and income earning capacity of a person. You should have a debt of up to 50% of your financial assets & if its above 100%, you need help. It means you can pay off your debts if required and you have a cushion to fall back on if value of assets go down or you have to take more loan.
When you are younger or have a bright career ahead with the potential to earn a lot of money in a short span of time, the debt taken can be larger compared to a time when you are nearing your retirement or the scope for earnings increase is limited. When you have to take a loan, you should have a look at this ratio before finalizing the loan.
The personal finance ratios help you to evaluate your financial position and take next steps. I have given a generalized target for the ratios. You should calculate your financial ratios, consider your personal, professional and financial situation and take measures to improve your financial health.
Have you calculated these ratios for yourself. What steps did you take after that?