The Ratios: Your Financial Health Report- Part 2

In part one, we saw some of the basic ratios which can clearly see if a person’s finance is under stress or if he has the capability to plan for future.

In this post we shall know more such ratios which look very simple to calculate. Once you have the numbers and you run the given below formulas, they will speak large volumes. The whole idea behind working on these numbers is to:

• See the current foundation strength (and weakness) in terms of current financial status. This gives a starting point to the financial planner to lay out a plan over the foundation.
• Picture the readiness of an individual to meet his future as per his goals and retirement. In investments, there are risks involved. The ratios identify the current and future responses to face these risks and counter them.

Ratio related to Risk Coverage

1. Life Insurance Coverage Ratio

 The ratio shows whether a family is able to meet its living cost, other expenses and reach critical goals in event of untimely death of the principal wage earner of the family. The ratio is calculated as:

Total Liabilities / Total Insurance Cover

The ideal ratio should be 100%. And this can be achieved by taking a combination of Term Insurance policies and Personal Accident covers as specified by your financial planner. Many investors overlook this and leave their family unsecured in hands of creditors who never forgo their principal and interest.

Ratio’s related to Liquidity

2. EMI Stress Ratio: also called as Debt Servicing Ratio

Few goals, especially for salaried individuals can only be met by leveraging. For major purchases like House or Education involves taking loans and paying back for long-term. The ratio checks the outgoing towards loans vis-a-vis income. It’s calculated by:

Total EMI / Total Income

The Ideal Ratio should be less than 35%. The extent of EMIs also depends on the stability of job or business and age of the person. But an amount more than 35% can put pressure on accumulation for future goals and current family lifestyle.

3. Liquid Assets to Monthly Expenses Ratio – The Contingency Fund

This ratio measures your ability to sustain a temporary halt in income. It measures numbers of months you can sustain if your income ceases due to any unforeseen event. It is calculated as:

Liquid Assets / Monthly Expenses

(Liquid Assets: Your savings in hand/bank and instruments which can be converted to cash to meet daily expenses.)

The ideal ratio depends on your line of work and your family lifestyle. Ideally you should have cash for 3-6 months. Maintaining a contingency fund also help you to manage accidental expenses like replacing any household article in case of breakdown like a refrigerator, enjoying a trip with friends or medical requirements, without breaking your long-term investments or resorting to credit. However, you should really think before using the contingency fund and if you use it your first aim should be to replenish it.

4. Financial Assets Ratio

Assets are classified as Financial Assets (like Shares, Bonds, Mutual funds, and Fixed Deposit etc.) and Physical Assets (Like Real Estate, Gold and other Precious Metals, Work of Art etc.). So if you plan to say start your own business, you shall try to ascertain what assets you have which can be disposed of quickly to generate capital. Financial Assets have better liquidity, flexibility, markets to exchange and easy to maintain. Financial Assets Ratio is calculated as:

Financial Assets / Total Assets

A higher proportion of financial assets is preferred especially when the person is advancing in age and closer to his goals.

In total, we have discussed 8 kinds of ratios in this and previous post and their importance in financial life. I would urge that you run these calculations on your own finances and expect some interesting result. My experience has been that we all are aware of our financial situation but do not counter them as no such evidence is in front of our eyes. These ratio test help you see clearly your financial strengths and gaps which need your attention.

Do share your views and interpretations in the comments section.