Many people take simple and extreme measures to steer their financial situations away from trouble or towards wealth. But most of us don’t even know what the goal is. If you are already in the midst of a new direction, you might not even know if real progress has been made.
The problem is that little or no effort was put in to specifically define your situation at the start. In order to measure progress, you need a starting point to compare against. When you are able to locate in which areas your main problems lie, you will be able to target and adjust them accordingly.
You can determine how strong your financial position is by using 5 ratios
1) Networth
2) Debt-to-income
3) Home expenditure
4) Savings
5) Liquidity
By putting extra work into working out the numbers from commencement, you will waste less time adjusting and navigating the activities you undergo to get where you want to be.
Networth
This is the most basic method to see whether you are comfortably going about your finances or drowning in the red. Just take your total assets, deduct your total liabilities, and you get your networth.
What you own (assets) – what you owe (liabilities) = networth
There are 3 classes of assets. Liquid, long-term, and hard assets.
Liquid assets consist of cash or cash equivalents, and assets that can be quickly converted into cash. So it would include the money in your current and savings accounts, stocks, unit trusts, mutual funds, REITs, exchange traded funds (ETF), bonds, etc.
Long term assets are those that can be quickly converted into cash, but only after a specified period of time. They included life insurance, pre-IPO share allotments, retirement plans, pensions, etc.
Hard assets are physical items of value that you can sell for cash. This includes you valuables like jewelry, antiques, gold, car, house, etc.
Liabilities are easier to quantify as they are basically what you owe. Make a list of them by including things like your rental, student loans, retail items purchased on instalments, personal loans, etc.
Once you obtain the total figure for assets and liabilities, do the subtraction to get your networth. The higher the number, the better. If you run into negative territory, it could be time to pay more attention to your personal finances. You might even have to take immediate action to avoid catastrophe. As you probably know, things like credit have a domino effect. 1 bad play can lead to total collapse.
Debt-to-income ratio
You can probably tell how this ratio is calculated. Ideally you want to shoot for as low a ratio as possible. However, some people insist that if your debt-to-income ratio is too low, you are not being savvy with money by using leverage. Well, in terms of financial position, the lower the better.
From the liabilities you have listed, now determine the total monthly payment you have to make. The sum will be the total monthly commitment you make to repay your debts. Next divide it with your monthly income.
Monthly debt / monthly income = Debt-to-income ratio
When lenders assess a loan application, they consider this ratio to determine whether your gearing is too high. When it exceeds a comfortable level, they reject the application. So you want to keep a low ratio if you are planning to obtain a mortgage soon.
The ceiling for banks is usually between 30% to 40%. This could either be set by regulations or by their own management team. However, even though banks could turn you away, it does not mean that all lenders will ignore you as well. This is where high risk lenders carve out their niche. Just expect to pay a higher interest if you are a high risk borrower.
Home expenditure ratio
The one financial commitment that we are most reluctant to compromise is home expenditure. Home is where we forge happy experiences and memories. It is where our children grow up. It is where we get away from the hectic world and recharge ourselves. It is little wonder that we seldom set a budget for it. When a pipe burst, you need to hire someone to fix it.
Take all the expenses you spend on your home and work out a monthly figure. Many types of bills like utilities can be irregular. In such cases, work out an average number. Then divide that with your household income.
Monthly home expenditure / monthly income = Home expenditure ratio
No prizes for guessing whether a low or high result is more favorable. Because home expenditure is close to being a fixed cost, you want a ratio as low as possible. The more your income goes towards maintaining your house, the less you have to support your lifestyle. Thread carefully if you are on 35% and above.
Liquidity ratio
In theory, liquidity ratio helps you learn how long you will last if you live off your cash. It’s just theory. But it is a good indicator of the strength of your cash flow. For many people wealth accumulation is a side show. Cash flow is king.
Total liquid assets / monthly expenses = Liquidity ratio
You should be able to tell that this is a ratio which you want as high a number as possible. If the result you get is 12, it means that your cash and cash equivalents will cover your expenses for 12 months. Not bad huh?
Savings ratio
I’m nobody to tell you how much of your income you should save. But generally, you want to put in at least 10% of monthly income into savings. You can put them into other liquid cash equivalents. But be mindful that things like stock can crash.
Monthly savings / monthly income = Savings ratio
Savings are supposed to be a buffer in case of cash emergencies. It should be a priority before you even consider putting extra money into investments. If you don’t have a safe financial foundation, how are you going to make sound investment decisions. Taking on too much financial risks can be detrimental to your family’s well-being.
Now what?
The odds are that you can feel it if you are slowly crawling your way into financial turmoil. And if you are rich, you probably never think about money problems in the first place. So these ratios would be most useful to those who don’t really know where they stand in terms of personal finances.
A good way to use these financial ratios is to work them out once a month or once every quarter. Then monitor whether you are on the up or going down. This should allow you to see troubled waters ahead and make plans to navigate to safer waters.