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Five Ratios to Evaluate your Financial Health

You all are aware that to be healthy various parameters of your body (such as blood pressure, cholesterol levels, Body Mass Index, sugar levels etc.) should be within certain desired range. If not, you need to take appropriate medication to bring them to normal levels.

But what about your personal finance? Have you ever evaluated your financial health? How do you know you are leading a financially healthy life? Or are you prone to financial illnesses such as poor returns, high debt exposure etc.?

Discussed below are five financial parameters that will help you to evaluate your financial health. And if you fall outside the safe zone, you need to take appropriate action to prevent any serious damage to your financial health.

1.  The Liquidity Ratio

Liquidity Ratio = (Cash + Balance in Savings A/c, etc.)/Avg. monthly expenses

As you would have guessed from the above equation, Liquidity Ratio essentially tells whether you can
'comfortably' meet any emergency needs or not.

You would have come across many instances when you were in sudden need of cash. There is a great investment opportunity (e.g. a crash in the markets); a sudden marriage has come-up in the family; someone needs to be hospitalized; etc.

We should be prepared for such unexpected expenses. If all the money is locked-up in long-term investments, you could incur a loss in converting them into cash. Sometimes you may not even be able to do so.

While, there is no perfect number, a ratio of around 3-5 is generally considered to be OK; i.e. money equivalent to about 3-5 times of your monthly expenses should be kept handy.

A lower ratio means that you run a risk of not having sufficient cash to meet the emergencies and too high a ratio means your money is losing out on returns.

2.  The Idle-Cash Ratio

Idle-Cash Ratio = (Cash, Balance in Savings A/c etc – Emergency Corpus)/Take-home pay
Any cash lying idle (over and above what you need to keep aside for emergencies) is a lost opportunity.

If this ratio is say up to around 10-15%, then it’s fine.

But a higher ratio means that you are lazy with your investments. This, in turn, means not earning higher returns on your funds. You are not making your money work efficiently for you.

In today’s world of conveniences – home service, online options, automatic investing etc. – this is simply not done. You need to immediately get down to the business of automating your investments as far as possible and as soon as possible.

3.  The Savings Ratio

Savings Ratio = Amount invested per month/Take-home pay

As life-spans increase and job-spans reduce, we all need to build larger retirement corpus to take care of higher no. of non/less-productive years. The more you save, the more capital you accumulate. That’s simple logic. But too much saving, at the cost of not enjoying the life today, is also bad. The idea is to get the balance right.

First, broadly work out what corpus would be sufficient for you to live comfortably from say the age of 50 to 80 if there were no other income. (Don’t forget to factor in inflation).

Now see if your present savings ratio is sufficient to build that corpus. If yes, then you need not worry. If not, you have to tighten your belts. However, there is a limit up to which this is possible. If, even after improving the savings ratio, there is still a shortfall expected then you either need to increase your earnings or have a re-look at your retirement corpus and make it more modest.

Is your financial health precariously balanced, or fit and stable?

4.  The Debt to Income Ratio

Debt to Income Ratio = Total loan EMIs per month / Per-month take home pay

Easy availability and low interest rates have made loans quite common. Nowadays, personal loans, home loans, vehicle loans, credit card outstanding balances, etc. all add-up to quite a sizeable amount.

Considering the uncertainties in life – job loss, accidents, terrorism, natural disasters, etc. – it would be advisable that one doesn’t go overboard with his loans.

Financial prudence demands that one’s DTI should not exceed 40-50%.

Further, ideally one should restrict oneself to loans for home or vehicles, that at least build some useful assets. Personal loans or credit cards usually finance consumption and should ideally be avoided or at best restricted to a DTI of 10-15% .

Also, you should try to become debt-free as you approach your retirement.

5.  The Solvency Ratio

Solvency Ratio = Total Assets / Total Loan and other liabilities

If tomorrow you were asked to pay-off all your loans by selling your assets, would you be able to do so?  (Assuming, of course, that every asset is readily convertible into cash).

If yes, you will not become bankrupt. If no, then you are living dangerously.

A solvency ratio of 1.5 or more is comfortable as it can withstand any fall in the value of your assets. Also, it leaves you with a cushion to borrow some more if required.

Solvency ratio of 1 or below is extremely risky and you must take immediate steps to reduce your debt levels.

Once you calculate these ratios, you can judge for yourself whether you are financially healthy or not. Accordingly, you can take the proper corrective action(s), if need be. 

An Investment In Knowledge Pays The Best Interest ~ Benjamin Franklin

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