Your expertise in personal finance determine its ability to manage it’s current and future needs and expenses. You get money from salary, business or profession or from assets created over time by saving and investing a portion of income. Creating assets to meet future income of household is good idea. If your income is insufficient, you can take loans to meet all these needs. This creates a liability for household. You need to settle that in future from the income. You also need to think about insurance. Meeting income needs in retirement is an important concerns and should be of paramount importance to household.
Investment advisor use various financial ratios to assess the financial position of the client like the analyst use various financial ratios to assess the financial position of company.
Important key points
1.Savings ratio determine your savings rate per annual income. It’s beneficial for longterm goal setting.
2.lower the Expense ratio better your financial health will be.
3.High lleverage ratio indicates bleak future for individual. It gives debt level in assets buildup in one’s life.
4.Always measure these ratio at regular interval. Make necessary changes if you have to.
If you get the data of your income, expenses, savings, investment portfolio, then you can get numerical snapshot of your current situation. It can help you to identify the areas that require changes and help set the course of action for the future. This gives you an important input in your situation.
Some of the important ratios are as follows
Savings ratio and expense ratio
It is the percentage of annual income that a person is able to save. You can calculate it as savings per year/annual income. For example Rajesh earns a annual income of 12lakhs and saved rs 2lakhs. So savings ratio is 2lakh÷12lakh =1/6=16.66%.
Don’t limit your money to only savings account, invest them in fixed deposit, mutual funds shares, debenture, national savings certificate, post office deposits, real estate, gold and others during the year. Your invested money will not go to yourself immediately but it will form a part of savings during the year. Annual income will include all the income earned from employment or business and in form of interest, dividend, rent and other such items during the year.
For example Rajesh earned a gross salary of 10000 including company’s contribution to provident fund of rs 500.Net take home salary was rs 9000 after deducting rs 500 towards employee contribution to provident fund. Rajesh earned rs 200 towards interest in savings Bank account. Expenses during the month were rs7000.
what is savings ratio?
Total income=gross salary+interest income=10000+200=10200. Savings:(net salary+interest income+contribution of employer and employees to provident fund) -(expenses) =9000+200+500+500 -7000=3200.Savings ratio =savings/total income=3200/10200=31.4%.
Savings to income ratio measure the total accumulated savings of individual relative to the annual income. It’s calculated as total savings/annual income. Consider the following information of the financial situation
Annual salary: Rs.12,00,000
Accumulated investments, including PF balance, value of bank deposits, mutual fund units, PPF, NSC: Rs. 15,00,000. Savings to Income ratio: Rs.15,00,000/Rs.12,00,000= 1.25. This ratio measures the preparedness to meet longterm goals such as retirement. Savings is total of current value of the investments and assets, after accounting for any outstanding loans.
Don’t include self occupied home when calculating the given ratios. Your age will determine the appropriate level. When you are young, your expenses will be high relative to income available and accumulated savings are low. At this stage, much of available usually go towards home loan. Ratio will improve in future when income goes up and expenses stabilize. A suitable savings to income ratio is three times the annual income. For example if ABC has saved 60000 out of income of rs 2lakhs , it stands to reason that 2,00,000-60000=140000 was spent towards various expenses.
Expense ratio is calculated as annual recurring expenses÷ annual income. In case it amounts to 1,40,000÷60,000=2.1%.
Expense ratio=1-savings ratio. Or savings ratio =1-expense ratio
Keep non recurring expenses out of the expense ratio. For example if a person incurred a one time medical expenses of rs 50000 in a year then that would be excluded. However if every family spends 30000 towards healthcare expenses, then don’t include that while determing the expense ratio.
Expense rratio may be mandatory such as taxes, rents, Emi for loans and necessities for living. Discretionary expenses are those expenses which are not essential. Target a low expense ratio and high savings ratio for better financial security and stability.
you can distribute your assets into various classes like stocks, bonds, dentures, gold, real estate etc. Buy Physical assets such as real estate with help of savings and loans. Exclude personal jewellery, residential house, any other assets meant for personal use.
Total lliabilities include loans and different forms of credit taken to meet expenses or to acquire assets. Sources are banks, financial institutions, friends, relatives. Liabilities are longterm and you secure them using mortgage towards purchase of house or car loans. Greater is liabilities more would be pressure on your financial life.
Leverage ratio
This measure the role of debt in assets build up of investors. Measure it by dividing total liabilities by total assets. For example an investor owns real estate worth 50lakhs, investment and bank balance valued at rs 10lakhs, rs 5lakh is lying in provident fund account. Investor brought real estate with loan of 30lakhs of which 10lakhs is currently outstanding. Investor has also credit card dues of rs 2lakhs, a loans of rs 1lakhs from a friend.
Total aassets=(50+10+5) lakh=65lakhs
Total lliabilities=(10+2+1) lakhs=13lakhs
Total liabilities=(10+2+1) =13lakhs
Leverage ratio=13lakhs÷65lakhs=20%
Higher the leverage more risky it is for the financial situation of individual. A ratio is greater than 1 indicates that the assets will not be adequate to meet liabilities. The ratio is likely to be high immediately after large ticket assets such as real estate. Purchase it with debt. Over time as assets value appreciate, ratio will also moderate. You need to look at the leverage in the context of debt servicing capabilities.
Networth
A strong asset position is of no use, if you acquire these with outstanding loans. Liabilities is not always bad if you acquire it for creating an assets like real estate which has the potential to appreciate in the value.
Always monitor financial position through net worth. It is calculated as total assets- total liabilities. In previous example netwrth =65lakhs-13lakhs=52lakhs.
Monitor networth over a period of time to know about improvement or degradation of financial position.
Solvency ratio
A person can be insolvent if liabilities are higher than the value of the assets held. A networth of individual should be positive. Using the solvency ratio you can measure the extent of solvency of a particular investor. Calculate it by dividing networth with total assets. For same assets position higher the solvency ratio stronger the investor’s financial position.
In above example calculate it as 52lakh÷65lakhs.=80%.
Calculate it as 1-leverage ratio. Similarly leverage ratio=1-solvency ratio.
Liquid assets
You can convert the liquid assets to cash at short notice to meet expense or emergencies. Liquid assets include money in saving bank account, fixed deposit that mature within 06months, investments in liquid fund other short term assets. On other hand there are assets which are not easy to convert into cash. For eg it can take long time to sell real estate assets at fair value. Some assets are easily liquifiable but their values may fluctuate widely in the short term thus making them unsuitable for realizing cash at short notice. Shares and open end equity schemes fall under this category.
Open-end debt schemes too have a significant market element in their valuation which makes their return volatile, and therefore unsuitable to meet the need for funds at short notice.
More the money in liquid assets, lesser are the chances of the investor getting caught in a liquidity crunch. However, keeping the entire money in liquid assets is not a sensible solution.
Liquidity comes at a cost. For example, banks usually offer lower rate of interest on shorter-term, liquid scheme may offer lower return than longer term debt scheme. Keep enough in liquid assets to meet liquid requirements and invest the balance in longer term assets with a view to earning superior return.
Liquidity ratio
we create liquids assets to meet short term cash requirements. Calculate the liquidity needs as the expense that an investor will incur over the following 6months. Liquidity ratio measures how well the household can manage it’s expenses from its short term cash requirements. It’s calculated as liquid assets÷monthly expenses. A ratio of atleast 4-6 indicates a comfortable level for household to meet its expenses for 4-6months, even if there was loss or decline in regular income. A ratio of around 6 indicates comfortable situation to manage short term obligations. Don’t include shares as liquid assets because uncertainty in value of the share makes it risky for an investor to include in liquid assets.
Liquid aassets to networth ratio
This ratio gets interpreted in light of the goals of individual. Longer period to the goals results in lower ratio. A high ratio indicates that a large portion is held in liquid assets and would be earning low returns. This would affect their ability to meet long term goals efficiently. If goals have to be met in near term then adequate assets must be held in easily realizable assets. Ratio needs to be higher in this case.
Debt to income ratio measures the extent of debt use in assets acquisition. It however does not directly measures the ability of the individual’s income to service or meet the obligations arising from all debt outstanding.
Debt to income ratio is an indicator of the individual ability to manage current obligations given the available income and a parameter used by lenders to determine eligibility for additional loans. It’s calculated as monthly debt servicing commitments÷monthly income.
Debt servicing refers to all payments due to lenders, whether as principal or interest. Consider an example where an individual has a monthly income of Rs.1.5 lakh and has loan commitments of Rs. 60,000 per month. The Debt to Income ratio = Rs.60,000/Rs.150,000= 40%.
A ratio higher than 35% to 40% is seen as excessive. A large portion of the income of the household is committed to meet these obligations and may affect their ability to meet regular expenses and savings. Obtaining loans in the case of an emergency may also become difficult.
Any reduction in income will cause stress to the household’s finances.Monitor ratios periodically or say once a year to identify problems. Take corrective steps accordingly.
