Four financial ratios you must know

Four financial ratios you must know

Picture this: you jog every day, eat healthy food and avoid too much stress. You feel absolutely fit and would never suspect anything can go wrong with you. But during one of the health check-ups, which you go for as part of your healthy lifestyle regimen, the doctor told you your blood pressure has shot up to 160:100 instead of the usual 120:80. You make amends and get it under control in a week or two.

Just as maintaining a particular ratio is important for your blood pressure, there are certain ratios you need to maintain for your financial health, too. On the face of it, your finances may seem in order, but a closer look may reveal it needs special attention at times. Here are four important ratios you must maintain to keep your financial life in order.

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Liquidity ratio

What is it: This ratio tells you whether you will be able to meet emergency needs with ease. It gives the number of months you will be able to meet your regular expenses in case your income stops suddenly due to, say, a job loss or a medical condition or disability.

How to calculate it: Divide your liquid assets by your monthly expenses.

Your liquid assets would include any cash that you may have stashed away in your savings bank accounts or elsewhere, or savings in fixed deposits or liquid funds. Usually, financial planners say that the money you have invested in equities or equity mutual funds shouldn’t be part of your liquid assets since the returns from these instruments are subject to market movement.

To calculate your monthly expenses, you will have to take into account rent, equated monthly instalments (EMIs), if any, insurance premiums, besides living and lifestyle expenses.

Once you’ve the two figures, divide the amount of liquid assets with your monthly expenses to get your liquidity ratio. For instance, if your liquid assets are worth 2 lakh and you spend around 1 lakh, your liquidity ratio is two divided by one, which comes to two. Which simply means that you will have two months of expenses available in case your income stops suddenly.

How much is enough: As per most financial planners, this ratio should be 3-6. In fact, the higher the figure, the more liquidity you have. If your liquidity ratio is say eight, then it means that you will have enough liquid assets to meet your current monthly expenses for the next eight months.

As a general thumb rule, a ratio of 3-6 is good, but this ratio changes with your age, income and financial situation. For instance, for someone who has a large income but relatively smaller average monthly expenses, a lower ratio number would work. But someone who has irregular income flow, a higher ratio number becomes mandatory. A person with a ratio less than two is definitely in the danger zone and needs to take some financial discipline measures right away.

Savings ratio

What is it: One of the most important ratios from the financial planning point of view, this ratio tells you whether you are saving enough for your future. It is basically the proportion of income you set aside as savings and is expressed in percentage terms.

How to calculate it: To reach this number, divide your savings per month by your net income per month. For instance, if you are saving 10,000 a month and your income is 1 lakh per month, your savings ratio is 10,000 divided by 100,000, which comes to 10%. This means you manage to save 10% of your income.

How much is enough: Generally, an individual should have a savings ratio of at least 10%, but most financial planners recommend that your savings ratio should be as high as possible.

Of course, this ratio changes as per your age, life cycle, income and individual circumstances. Says Suresh Sadagopan, financial planner, Ladder7 Financial Advisories: “If you are in your 30s, you need to have a ratio of 5-10%, considering that you may have higher number of loans to service and more lifestyle expenses. In early 40s, it should be 25%. By 45, it must be 30%, considering that your income would have increased substantially by then. By 50 years, it should be well above 30% since by then you would have paid off most of your loans. Above the age of 50, your savings ratio should be as high as possible."

If your savings ratio drops below 5%, your financial future could get in some serious jeopardy. So, act now.

Debt-service ratio

What is it: This ratio is the portion of your income that goes to repay your debts and shows you how far are you from a debt trap.

How to calculate it: Divide your total EMIs on all your loans and debts by your total monthly income to get this ratio. For instance, your home loan EMI is 12,000, car loan EMI 5,000, personal loan EMI 3,000 a month and a credit card minimum due payment of 5,000, your total debt stands at 25,000. If your salary is 50,000, the debt-service ratio would be 25,000 divided by 50,000, which is 50%. In other words, half your salary goes into paying your EMIs and debts.

How much is enough: Conservative planners believe that your debt service ratio should be 30-35%. Therefore, of every 100 you earn, 35 should go into servicing loans.

But in today’s times, it is difficult to survive without taking loans. Keeping that in mind, many planners suggest that this ratio could be higher. Ranjit Dani, Nagpur-based certified financial planner says, “Debt-service ratio should be around 40-45%." Anything more than that means you are in a vicious debt trap. Again this is a general number. Someone with a very high net-worth may afford to have a slightly higher ratio compared with someone with a lower income.

Leverage ratio

What is it: This gives you the level of debt you are into in relation with your assets.

How to calculate it: Divide your total liabilities by the total assets you may have. It is expressed in percentage terms. For instance, if your total liabilities is 7 lakh and the value of your total asset is 10 lakh, your leverage ratio is 70%.

How much is enough: Your leverage ratio should never be more than 50%. Say if your leverage ratio is 70%, it tells you that 70% of your assets are currently financed by debt. A high ratio is a dangerous since any increase in interest rates may get you in a tight spot.

There are many more ratios, you could refer to, but the ones mentioned here will pretty much let you know how you are doing financially. If you think you are falling short on any of these, it’s time for a financial work-out.