While we continuously postpone the task of making investments or following financial discipline to another day, there are some simple tools in personal finance that can serve as benchmarks to help us gauge our financial situation. Just as we evaluate a company’s balance sheet with Financial Ratios, our Personal Finances also can be assessed with the help of a few simple ratios. The task, though, is much simpler compared to analyzing Balance sheet of a company.
All it requires is your basic financial details like bank balance, loan amounts and knowledge about the values of your assets.
Let us take a look at some important Personal Financial Ratios –
To tide over times of uncertainty such as a job loss, change of location or a sudden illness, it is critical to have money placed in liquid assets that are easy to encash. Basic Liquidity Ratio indicates expenses worth how many months are provided in the form of Liquid assets, to sustain such uncertain times.
Basic Liquidity Ratio is calculated by dividing Liquid Assets like SB A/cs, FDs, RDs by monthly expenses.
It is ideal to set aside about 4 months of household expenses including EMIs on loans, in an Emergency Fund. For single-income families, widows and divorcees who are sole bread-winners for their familiesor single working women this can be 6 months of household expenses including EMIs on loans.
As the name suggests, this ratio indicates percentage of Net Income saved every year.
Annual Savings Ratio is arrived at by calculating Annual Savings as a percentage of Annual Income. A higher ratio here is always desirable, as it indicates higher savings put aside.
Annual Savings ratio of 25-40% is good number that one should aim to achieve. However, the ratio need not be so high that one tends to miss out on basic luxuries in life in pursuit of higher savings.
The Assets that we hold can be broadly classified as Investment Assets and Personal Assets. As the name suggests, assets created by investing our own money and which generate either income or capital gains or both fall under the category of Investment Assets. Portfolios of shares or Mutual Funds, Real Estate, Bonds are examples of Investment Assets.
Personal assets are acquired for one’s personal use and include gold, jewelry, automobiles which do not appreciate or sometimes even depreciate.
Such assets can be easily used to fund goals as against Personal Assets that will have to be pledged if they are to be used to fund Long-term goals. This ratio indicates the percentage of Investment Assets in the Total Asset Mix of a person.
Here a ratio of 50% and more is desirable. While personal assets are needed for convenience in day to day life, one also has to carefully build up Investment assets that will help to fund future aspirations.
This ratio tells us how much portion of a person’s Net Income goes into repayment of debt. While one has to take on debt to build Long-Term assets, care needs to be taken to build income generating assets along with Personal assets, with such debt.
A good rule of thumb is to have Total Debt-to-Income Ratio of less than 36%. If you have multiple loans, Home loan EMIs should not be more than 28% of monthly income. That means, you should ideally aim to have all other loan EMIs at less than 8% of your monthly income when you have taken multiple loans.
A lower Total Debt to Income Ratio is always desirable, as the rest of the Income will be available for funding living expenses and emergencies, if any. It also leaves you a room to take on more debt, if there is a need for it in the future. Higher proportion of debt may not only stress current finances, it may also compromise long-term goals.
Discretionary Expenses are now an integral part of living expenses. These are also termed as lifestyle expenses. Fine dining, branded clothes and accessories, regularly attending sport events or concerts are all examples of discretionary spends. This ratio indicates what portion of your monthly Income is spent on discretionary expenses.
A ratio of 15-20% can be termed as satisfactory ratio. While it is good to spend some amount of your Income on such expenses, they should not spiral out of control. High amount of discretionary spends mean income is just spent away on luxuries without regard to future liquidity or long term goals.
This ratio helps to understand how much life Insurance a family’s principal wage earner has. It is a good indicator of whether the family will be able to sustain living expenses and meet important long-term goals in the event of untimely death of their bread-winner.
Life Insurance needs can be determined in two ways – Human Life Value (HLV) method or Expense Method. HLV is arrived at by estimating the net present value of all future income that a person expects to earn less personal expenses, life insurance premiums and taxes till his planned retirement date. As against, Expense method of estimating Insurance needs takes into consideration all the expenses needed today for child education and marriages, provision for non-working spouse, dependent needs and any other needs, for arriving at one’s Insurance needs.
Life Insurance coverage ratio will determined based on the salary or expense levels of the person to be insured.100% coverage, while desirable, may be difficult to attain as Life Insurance needs change with time, with the salary and expenses of a person increasing year after year. Hence, one needs to keep reviewing his Insurance needs and buy additional Insurance in order to have a 100% Life Insurance Cover. A ratio of 75% can be still considered ok, as it means that majority of expenses and important life goals will be taken care of, in the event of death of the insured.
Conclusion
All the data required for this exercise is easy to get and the work is really not so complicated. While all of the above ratios may not be relevant to people of all age groups, they serve as handy tools for a quick reality check. Most importantly, you should be willing to make corrections in case something is amiss, to really benefit from these parameters. So what are you waiting for?
Credits Dilshad Bilimoria
Source:www.dilzer.net