It is better and simple to analyze personal finance ratios to evaluate an individual's financial situation and financial health. Financial planners are more comfortable using ratios for better understanding and decision-making. The following ratios have been discussed to help for better financial prudence.
Liquidity or Emergency ratio = Liquid assets / Net worth
One has to keep a few months of expenses in liquid assets in absolute money terms. The Liquidity Ratio indicates the percentage of net worth invested in liquid assets. It should be between 5% to 15%. Liquid assets include cash, bank balance, investments in cash, and cash equivalents with a brief maturity period. Net worth is a balance of assets and liabilities. A higher ratio indicates that funds are not used for a productive purpose, lying ideal, capital, and money could have been invested for better returns. A lower ratio indicates that a person can run a risk of going short of cash to meet regular expenditures or emergency needs.
Investment ratio = Actual investments / Post-tax income
The investment ratio indicates how much money is invested out of post-tax income for a given period. It should be over 25%. The higher the ratio, the better it is. However, investments should be in the right asset classes. It covers asset-building EMIs, like home loans, insurance premiums, mandatory salary savings. It helps to understand that how much you are investing in securing your future.
Expense ratio = Actual expenses / Post-tax income
Expenses can be fixed or variable, where fixed expenses are utility bills, rent, children’s tuition fees, EMIs of car/personal loan, salary to servants, etc. Variable expenses will be grocery, entertainment, shopping, etc. To understand the spending pattern, look for the proportion of fixed to variable expenses with post-tax income. A higher variable expense ratio indicates that more expenses are made for unnecessary things which have to be controlled.
The expense ratio indicates how much of post-tax income is spent in any given period. It should not be beyond 75% of the income. The lower the ratio, it is the better.
The relationship between investment and expense ratio is investments + expenses = post-tax income. Expenses are net income, and investments rather than investments are residual after meeting all expenses. In this way, we can limit and control our expenses and increase investments. So one has to pay for himself first then spend. Also, please read our article “Know about pay yourself first.”
Debt to assets ratio = Total liabilities / Total assets
The debt to assets ratio is the relative proportion of total debt to total assets of an individual. 100% or above of debt to assets is undesirable. The lower the ratio, the better it is. However, due to liabilities like car and home loans, it is usual to find an even higher debt to assets Ratio. While considering assets, one can either consider only disposal assets or total assets or derive a ratio for both. A lower Debt to Assets ratio would mean a person has greater flexibility to maneuver his financial situation.
Debt repayment ratio = Debt payments / Post-tax income
The Debt repayment ratio is used to understand the portion of an individual's post-tax income that he is spending on loan payments. It should be below 40%. The lesser it is, the better. The loans consist of car, home, personal, private loans, etc. If it is 50%, it indicates that one is in the debt crisis and should minimize its debt.
The above ratios are for broad guidance, and there can be a deviation from the figures given above. For a working couple or an unmarried person, the investment ratio can be higher than a family with one working spouse and children. We also have to consider exceptional cases like retired persons, where there will be no post-tax income. In such cases, a low investment ratio and a high liquidity ratio are acceptable. Although these ratios cannot be used for complete financial planning, they can serve as a valuable reference point for a better understanding of a person’s financial situation.
By Team Wealth ATM
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