Yahoo Finance DIY: 6 simple ratios to evaluate financial position and health
In financial planning, one of the first steps is to ascertain an individual's current financial position. The personal financial situation of a person refers to his / her ability to manage current and future needs and expenses.
Current and future expenses are met primarily through income (from salary / business / profession) and assets generated by saving a portion of income over time. Assets are created / Savings are made to meet future milestone expenses like marriage, purchase of property, education of children, foreign holidays, etc.
Loans are also used to meet current / future expenses, if income / assets are insufficient. However, taking loans means pledging part of future income for servicing debt. It must be used with caution, ideally to acquire assets which appreciate in value.
The complex interplay between income, expenses, assets and liabilities, and the way an individual handles the same determines his / her financial situation.
There are a few ratios which are very simple to calculate and can be used to ascertain one’s financial position.
Savings and Expense Ratio
Leverage and Solvency Ratio
Savings to Total Income Ratio
Debt to Income Ratio
Liquidity Ratio (2 Methods)
Financial Assets Ratio
Illustration 1: Gross salary of A for the year is Rs 5 lakh. He gets an in-hand salary of Rs 4 lakh after tax deducted at source (TDS) of Rs 50,000 and provident fund (PF) contribution of Rs 50,000. He spends Rs 3.5 lakh annually and saves Rs 50,000 in fixed deposits.
In this case A’s savings is Rs 1,00,000 (fixed deposits plus PF). A’s expenses are Rs 4,00,000 (routine expenses plus income tax).
Savings Ratio = Savings ÷ Income = 1 lakh ÷ 5 lakh = 20%
Expense Ratio = 1 - Savings Ratio = 1 - 20% = 80% or
Expenses Ratio = Expenses ÷ Income = 4 lakh ÷ 5 lakh = 80%
The higher the savings ratio, the better. There is no ideal savings ratio, however one can compare it with the national savings rate which is around 30%. Another variant of the savings ratio is called Savings to Total Income Ratio.
Savings to Total Income Ratio = Accumulated Savings ÷ Annual Income
In the above example, if A has been saving Rs 1 lakh each year for 5 years, A’s total savings is Rs 5 lakh at the end of year five. For simplicity, let’s assume A’s income increases to Rs 7 lakh per annum during this period.
Savings to Total Income Ratio = 5 lakh ÷ 7 lakh = 71% or 0.71 times
The ratio measures the preparedness of an individual to meet his /her long term goals. As income grows, and as you age, this ratio is likely to improve. For a person in their 40s, the thumb rule is that this ratio should be at least 3.
In the above illustration, let’s assume some years down the line, the assets and liabilities position of A is as under.
He has a house market value of which is Rs 40 lakh, Fixed Deposits of Rs 10 lakh, PF of Rs 5 lakh and Mutual Funds of Rs 5 lakh. His total assets are worth Rs 60 lakh.
He took a loan of Rs 30 lakh to purchase the house, and currently Rs 23 lakh is outstanding. His credit card outstanding is Rs 1 lakh. His total liabilities are Rs 24 lakh.
Leverage Ratio = Total Liabilities ÷ Total Assets = 24 lakh ÷ 60 lakh = 40% or 0.4 times
The lower the leverage ratio the better. A ratio of more than 1 shows that assets are not sufficient to meet liabilities and the person is insolvent. A strong asset position is of no use if most of it is acquired through loans.
Net worth is one of the most common metrics used to monitor an individual’s financial position. It should be positive and not negative.
Net Worth = Total Assets − Total Liabilities = 60 lakh - 24 lakh = 36 lakh
Solvency Ratio = Net Worth ÷ Total Assets = 36 lakh ÷ 60 lakh = 60% or 0.6 times; or
Solvency Ratio = 1 - Leverage Ratio = 1 - 0.4 = 0.6
Solvency ratio more than leverage ratio denotes a very comfortable financial position.
In the above illustration, income of A has increased to Rs 7 lakh per annum. For simplicity let’s assume income tax and PF contribution remain at Rs 50,000 each. Net home salary is Rs 6 lakh per annum, or Rs 50,000 per month. The house which he has bought has an EMI of Rs 20,000 per month.
Debt to income ratio indicates the debt repayment or servicing capacity of the individual. It shows whether income is sufficient to meet the EMIs. It includes principal as well as interest component of loans.
Debt to Income Ratio = Monthly Debt Repayment ÷ Monthly Income (Net) = 20,000 ÷ 50,000 = 40%
The ratio of A is in the satisfactory range. A ratio higher than 35% to 40% is considered excessive as it shows a large portion of income of the household is committed expenditure with little room for meeting regular expenses. It points to the fact that any reduction in income could cause undue financial stress.
Banks usually look at this ratio while calculating the eligible loan amount. If your EMI after taking the loan is more than 40%, banks may reduce the loan amount offered. If the ratio is more than 40% it may get difficult to borrow additional money / get new loans.
Illustration 2: B has total assets of Rs 50 lakh comprising sticky assets of Rs 40 lakh ( House of 35 lakh + PF of 5 lakh) and liquid assets of Rs 10 lakh (Short Term FD + Open ended Mutual Funds). B has loans outstanding of Rs 30 lakh.
Sticky assets means assets which can not be readily converted into cash in case of any exigency. Real estate takes time for sale and in PF too there are many formalities / conditions for premature withdrawal.
It is important to have liquid assets in your portfolio. If a high proportion is kept in liquid assets, individuals are less likely to be caught in a liquidity crunch. However, it also means that returns could be lower, like in FDs. That is why it is very important to match liquidity and return considerations.
Liquidity ratio measures how well the individual is equipped to meet monthly expenses from liquid assets. In the above example, let’s say B’s monthly expense is Rs 1.5 lakh.
Liquidity Ratio = Liquid Assets ÷ Monthly Expense = 10 lakh ÷ 1.5 lakh = 6.6
The role of liquid assets is to meet the near term expenses of the individual say, 4 to 6 months. It shows how many months an individual can survive (meet lifestyle expenses) in case of job loss or loss of income. A ratio of 6.6 indicates a comfortable liquidity position. Post the pandemic, this ratio should be anywhere between 6 to 12 for comfort.
There is another variant of the Liquidity Ratio.
Liquidity Ratio = Liquid Assets ÷ Net Worth
In the above example, B has total assets of Rs 50 lakh and liabilities of Rs 30 lakh, his net worth is Rs 20 lakh.
Liquidity Ratio = 10 lakh ÷ 20 lakh = 0.5 or 50%
This ratio has to be interpreted in the light of the goals of the individual. If there is a longer period to the goals (> 5 years), the ratio needs to be low, as more savings can be deployed in assets which fetch higher returns.
If there is a shorter tenor (<1 year) to the goals, then the ratio should be higher, closer to 1, as one would need funds in the near term.
In the above example, B has total assets of Rs 50 lakh. It includes physical assets of Rs 35 (house) and financial assets of Rs 15 lakh (PF + FD + Mutual funds). Other examples of physical assets include gold, commodities, vehicles etc. Other examples of financial assets are shares, debentures, bonds, PPF etc.
Financial assets have the advantage of greater liquidity, flexibility, convenience of investing and ease of maintaining. Physical assets have safety issues, they can suffer wear and tear and are less liquid.
Financial Assets Ratio = Financial Assets ÷ Total Assets = 15 ÷ 50 = 30%
A higher proportion of financial assets is preferred especially when goals are closer to realisation and when there is a need for income or funds to meet the goals.
If after carrying out this exercise, an individual finds that savings ratio is 30%, debt to income ratio is between 35% to 40%, leverage ratio is low, solvency ratio is more than leverage ratio and liquidity ratio is more than 6, then his / her financial position is sound.
As per National Institute of Securities Markets, “Personal Finance Ratios need to be calculated periodically, say once a year, and compared with past numbers to identify trends. They help identify areas where corrective action needs to be taken to improve the financial situation. The trends also show the efficacy of actions already taken. While benchmarks have been established for each of the ratios, they may have to be customized to each individual’s situation.”
So, what are you waiting for? DIY is the in-thing nowadays. Use these 6 ratios to find out your financial position.
DON’T MISS:
The anti-BJP, united Opposition math does not work. Here's why
Parliament deadlock: 5 reasons why Opposition is losing the plot
2 years of abrogation of Art 370: Modi govt’s 5 achievements
