Your financial toolkit
It’s good to seek professional help in managing your money. But you too should know about the tools used by financial planners. Here are five widely used ratios and what they mean:
Liquidity Ratio
This measures your ability to use your assets to immediately pay for any liabilities (sudden large medical bills, for instance).
Liquidity Ratio = Liquid Assets / Monthly Expenses
Target: 5-7 months
What it means: You have 5-7 months of emergency funds to live on if you go bust today (for instance, if you lose your job or your business closes down).
Housing Payment Ratio
This is the percentage of your housing payment (principal, interest, taxes and insurance) to your monthly gross income. Lenders use this ratio to qualify you for a loan, so keep an eye on this.
Housing Payment Ratio = Housing Costs / Gross Income
Target: Less than 0.3
What it means: Keep to the target and you will be well able to stomach any sudden increases in the interest rate.
Solvency Ratio
Measures your ability to service debts and other obligations. Helps you assess how much you can stretch your finances.
Solvency Ratio = Total Assets / Total Debt
Target: Greater than 1
What it means: If this falls below 1, it means you have more debt than assets. You are safe if you have a solvency ratio of more than 2-3.
Savings Ratio
This ratio is also expressed as a percentage of the disposable income that you save. The higher it is, the more aggressive the saving rate.
Savings Ratio = Savings Per Year / Annual Gross Income
Target: 8-25% depending on age
What it means: Usually, the younger you are the more you are able to save. If you’re under 30 and single, aim for at least 20%.
Debt To Income Ratio
This is also expressed as a percentage and denotes your gross income that goes towards paying your debts. It is good to keep this low, but zero debt is also not good.
Debt to Income Ratio = Debt Payment / Gross Income
Target: Less than 30%
What it means: If you include credit card rollovers, the target can go up to 40-45% in the higher income category. But this could delay some financial goals.
Reading The Ratios:
Understanding ratios is just the first step. Keep track by asking yourself the following questions:
- Has your net worth grown by more than the inflation rate? If it has not, determine the reasons.
- What is your ratio of assets to liabilities? A ratio of less than 1 means you have more liabilities than assets. Cut your liabilities.
- What are your liabilities? Review the amounts and types of debts. Loans to buy assets that appreciate in value are considered “good” debt. Credit card rollovers and auto loans should be kept to a minimum.
- What percentage of your assets is liquid? Non-liquid assets include real estate, jewellery, and works of art. Liquid assets, such as bank accounts and stocks, are easily converted to cash. You need them for emergencies.
- What is your savings to income ratio? For this ratio, your savings is taken as all assets designated to help fund your retirement. It typically won’t include your home.
- What is your savings rate? Calculate what percentage of your income you are saving on an annual basis. You should aim at a minimum of 10%.
- How have your investments performed? Measure the performance of each investment, comparing it to an appropriate benchmark. This can help you change your portfolio.
