Personal finance ratios are as important to an individual investor as are stock ratios to the health of a company.
You have stock analysts, market pundits, punters and ordinary investors predicting the path of a stock after analyzing basic stock ratios like EPS and PE; however, none pause to think about the personal finance ratios that could help to measure and analyze their fiscal health and contribute to their healthy financial planning.
We analyze some personal finance ratios to help you assess where you stand financially.
The Savings ratio tells you how much you are saving annually or monthly.
Savings = Monthly savings / Total pre-Tax monthly income
Example : Mr InvestorOrdinary is 35 years old and his current monthly savings are Rs 20,000. His pre tax monthly income is Rs 50,000.
His Savings to Income ratio = 20,000 / 50,000 = 0.4 or in percentage terms it is 40%.
This means that he is saving 40% of his monthly income.
Inference : The more the Savings ratio, the better it is. Generally, a minimum of 25% of your total monthly income should be saved. The more, the merrier.
Debt to Income Ratio
The Debt to Income tells you the total monthly income that you spend towards servicing any kind of debt you have – home loan, car loan, personal loan amongst others. The idea of the Debt to Income ratio is to move from high debt and low savings to low debt and high savings.
Debt to Income Ratio = Monthly debt / Post-Tax monthly income
Example : Mr InvestorOrdinary is 35 years old and his current monthly debt is Rs 7,000. His post tax monthly income is Rs 42,000.
His Debt to Income ratio = 7,000 / 42,000 = 0.1667 or 16.67%
Inference : If you look closely, you will infer that a young person, say aged 30, will have more debt than an old person, say aged 55. Therefore, the ratio will be higher at age 30 and lower or zero at retirement age. The lower this ratio, the better it is. The general guideline is to keep your debt below 40% – 45%.
Basic Solvency Ratio
This ratio captures the investor’s ability to meet monthly expenses in case of emergency. If your source of income stopped due to an emergency, for how many month’s will your money last ?
Basic Solvency Ratio = Liquid Assets / Monthly expenses
Liquid assets will include cash in savings account, bank fixed deposits, liquid mutual funds, cash in hand. However, direct equity and equity diversified mutual funds do not qualify as liquid assets.
Monthly expenses should include all mandatory contributions of loans; EMIs; insurance premiums and household expenses like food, utilities, transportation, education, medical care.
Example : Mr InvestorOrdinary is 35 years old and his current monthly expenses is Rs 10,000. The liquid assets he has amount to Rs 25,000.
His Basic Solvency ratio = 25,000 / 10,000 = 2.5
This means that his money will last him for only 2.5 months.
Inference : This ratio is used for contingency planning. It is said that generally monthly expense of more than or equal to 3 months is good to have. As you grow old and near retirement, the ratio should increase as the money for emergency purposes needs to be set aside for a longer duration.
In the above Basic Solvency ratio, you must have noted that we talked about liquid assets which could be converted into cash very quickly. However, there is another personal finance ratio which can be calculated if we take into account all your assets which could be converted into cash rather quickly, say within 3-4 days. It is called the Liquidity ratio.
The liquidity ratio is helpful in catastrophic circumstances when you need to liquidate much more of your assets than just the liquid assets seen in Basic Solvency ratio.
Liquidity ratio = Liquid Assets / Personal Net worth
Liquid assets will include cash in savings account, bank fixed deposits, liquid mutual funds, cash in hand, direct equity and equity diversified mutual funds.
Example : Mr InvestorOrdinary is 35 years old and his current net-worth is Rs 100,00,000. The liquid assets he has amount to Rs 5,00,000.
His Liquidity ratio = 5,00,000 / 100,00,000 = 5
This means that 5% of his assets can be converted into liquid assets at a short notice to meet contingencies.
Inference : An ideal Liquidity ratio of 15% is good. A higher liquidity ratio will help you tide over emergencies which are of catastrophic nature. Remember that direct equity and equity diversified mutual funds that you hold are probably for a future financial goal that you have (read more on goal based investing), and you would only liquidate these in case of extreme emergencies.
Do you use any of these personal finance ratios in your financial planning ?