Everything gets measured in this world. Everything around us, whether it is physical or non-physical has a measure. In the field of finance & corporates, these measures assume great significance. There are many measures in the financial fields for evaluating stocks, valuations of companies, the credit quality of lenders, return potential for opportunities, and so on. Most of the measures are in form of ratios like for eg., Price to Earnings (PE) ratio, Dividend Yield ratio, etc.
Have you ever wondered about how can you evaluate your own financial health? What measures would be appropriate for you? There are a few measures that you can use to assess your own financial health. One would have to take the effort of actually measuring their financial health.
RATIOS FOR ASSESSING FINANCIAL HEALTH:
EMERGENCY FUND RATIO
Formula: (Cash + Bank Balance) / (Monthly Living Expenses)
Ideal Value: 3 to 6
This ratio measures your ability to pay for expenses with cash in hand.
This ratio indicates an individual’s ability to meet its’ monthly expenses in case of an emergency. Typically, one should have enough cash + bank balance to cover for 3 to 6 months of living expenses. There is no exact measure but typically would be higher for those with high chances of unforeseen expenses, variable income, change in job or unemployed, start-ups, etc where risks are higher. Those with stable jobs and settled in life stage can follow the ratio at a lower end. It does not include voluntary expenses like those on entertainment, vacation, or those that can be avoided if needed.
Formula: Liquid Assets / Net Worth
Ideal Value: 10% to 20%
This ratio helps a person to know his financial liquidity.
Typically any person would be investing in multiple avenues/asset classes and products – both financial and non-financial. Prudent personal finance planning requires us to maintain a certain level of liquidity in our holdings to face any unforeseen financial challenges. Investments in say property can be a good investment avenue but lack of liquidity is its’ biggest negative. Typically, we must have at least 10% to 20% of holdings into liquid assets/products which can be redeemed at a short notice. Anything less is not healthy.
Liquid assets can include all cash (near cash assets), equities, Equity Mutual Funds (except ELSS with lock-in period, FMPs & closed-ended funds), Debt Funds and other assets which can be redeemed within three to four working days.
Formula: (Amount saved per month) / (Total Income per month)
Ideal Value: 20-30%
This ratio indicates the savings made from the total income earned for a given period, say a month.
Every family must save some portion of their income to ensure some wealth creation over time. The extent of savings depends a lot on the income earned, life stage,expenses of the person and so on. A minimum 10% can be considered as a must while we must aim for at least 20-30% savings from our total income. The savings can be in form of cash, bank balance, mutual fund, etc. Total income includes income earned through business, profession or in the form of salary, bonus, EPF contribution, interest, dividend, rent/royalty and any other form of income.
DEBT SERVICE RATIO
Formula: (Total debt payments /EMIs) / (Family Gross Monthly Income)
Ideal Value: Below 40%
This ratio shows the ability of a person to pay the loan installments on a regular basis. It indicates how much percentage of your monthly income is used for paying loan EMIs. Typically, the disposable income of a family would be portion which remains after paying the EMIs as such payments cannot be avoided. The lower this ratio, the better it should be for you to manage your finances and save. Typically 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 payment should not be more than 40% of your income.
Formula: (Financial Assets) / (Total Liabilities)
Ideal Value: >= 1.5
This ratio assesses the total assets and total liabilities to find if the person has the ability to pay off his debts.
The higher the ratio, the better is the person’s financial situation as the ratio indicates the debt carrying capacity of the person. Ideally, the total debt of a person should not exceed 50% of his disposable /financial assets. A ratio of less than 100% simply means that you are in a bad financial situation and you need to get rid of your debt soon. A higher ratio of over 150% would mean that you could easily sell of some of your assets and pay off the debt.
Formula: Total Assets (less) Total Liabilities
This last measure ie., Net Worth is not a ratio but an important direct measure of your financial strength. It is the amount left after deducting total liabilities from total assets. Your net worth is a snapshot of your financial life at one moment in time, a single number representing your financial health.
Net worth is a concept applicable to individuals and businesses as a key measure of how much an entity is worth. A consistent increase or decrease in net worth indicates good or bad financial health.. Net Worth can be used as targets to track changes in financial life.
The personal finance ratios help you to evaluate your financial position and helps to take next steps for better improvement. The ideal ratios can be used as general targets and you can then plan your finances / portfolios accordingly. To keep a period record of your ratios and tracking them over time helps you to take measures to improve your financial health.