Financial Ratios – Check Your Financial Health Using these Financial Ratios
Every individual should use these personal financial ratios to ensure the financial well being. These financial ratios can provide warning signals that can help investors adjust the financial situations as needed.
How do you check the health of a stock? By looking at various financial ratios, right? A typical investor would look at the PE ratio, debt-equity ratio, ROCE, ROE etc.
How about your own personal financial health? Just as you would want the PE and the debt-equity ratio to be low, you would expect ROCE and ROE to be high and trending higher.
Similarly, you should track a few personal financial ratios and make sure they are trending in the right direction.
Let’s analyze some of the most important financial ratios that will help you assess your financial strength.
Common Terms
Let’s define a few basic terms that we will use in the personal financial ratios.
- Salary (monthly income) – this is your take home salary. Some people use pre-tax salary. I like to consider ‘take home’ salary. After all, that’s all the money we bring home. To this, you can add the PF component if you wish. If you have additional income, it should be added too.
- Savings – this is the net savings at the end of each period.
- Debt – this is the total of all monthly payments.
- Liquid Assets – anything you can turn into cash in 3-4 days. This can include stocks, bonds, bank deposits, cash etc.
- Monthly Expense – to be conservative, this should include all your monthly expenses – fixed, variable, discretionary as well as non-discretionary.
- Net worth – this is your net of all your assets and liabilities.
Personal financial ratios are very important in evaluating your financial health
Fiancial Ratios
Savings Ratio – this ratio tells you how much you save every year. It is calculated as
Savings Ratio = Savings / Salary
Each month, make a note of your savings, and your salary (or monthly income). At the end of the year, add up all the savings and divide by the annual income.
Keep a track of this ratio. Over time, you should see this ratio go higher.
If you buy a home and get a home loan, this ratio will dip, but that’s ok as you are using your money towards building a new asset.
Debt Quality Ratio – this ratio tells you how much of your debt doesn’t produce anything. It is defined as
Debt Quality Ratio = Non-Asset-Producing Debt / Total Debt
Non asset producing debts are the ones where money was borrowed to spend rather than to invest. Examples of Non asset producing debts are personal loans, credit card loans, car loan etc. If you are making monthly payments towards these loans, that money is not producing anything today. I also put student loan or educational loan in this category since the payment towards these loans is also not adding to your future assets.
Loan to purchase real estate is a different kind of loan since you have an appreciating against it.
Hence this ratio should continue to reduce over time. It is critical to get to zero as soon as possible.
Again, it is a good idea to track this ratio at least one a year.
Emergency Ratio – You would have heard many a times to keep 3-4 months-worth of expenses in a savings account for emergency. This is basically your emergency ratio. It is defined as
Emergency Ratio = Liquid Assets / Monthly Expenses
This should be between 6 and 12. If you have a significant investment in stocks and bonds, this ratio can be very high, and that’s ok.
The purpose of this ratio is to make sure it is at least 4
Liquidity Ratio – This is the ratio of your liquid assets to your net worth. It is defined as
Liquid Ratio = Liquid Assets / Net Worth
The use of this ratio is to ensure that you at least some percentage of your net worth is liquid. The liquid assets should be at least 15% of your net worth. The reasons to have sufficient liquidity are as follows –
- Emergency – if you have to liquidate some assets in a hurry, will you be able to do it?
- Alternate Investment Potential – if you see another potential opportunity, will you be able to invest into it?
The important thing to keep in mind is, you want to see these ratios improve over time. It is the trend that matters than the absolute ratios themselves. Create a simple Excel sheet and start plotting your personal ratios every quarter. Very soon you will have a trend