Welcome again, you ratio followers.
After checking for debt traps and your safety margins in the previous issues of this series on personal financial ratios, let us now graduate a little more and dwell deeper to check for your long-term solvency. By definition, solvency means the ability of an entity to pay off its debts with available cash.
So how do we go about determining this solvency? By using a fairly simple but effective ratio, the solvency ratio.
This ratio is used to check your potential long-term solvency, that is, the measure of how much you are left with after paying your liabilities from your assets to avoid any solvency problem. Thus,
Solvency ratio = Total net worth / Total assets (total net worth divided by total asets)
Where, your total net worth would consist of your total assets less total liabilities. The balance is your total net worth.
And total assets would include:
- Cash/near cash assets (which includes savings account, fixed deposit, liquid funds and cash in hand)
Invested assets (which includes all your invested assets like equities, equity and debt mutual funds, bonds, Public Provident Fund, real estate, and any other form of invested assets but at their market price.)
Personal assets (which includes your house, jewellery, vehicles and any other assets you own)
And total liabilities would include:
- Current liabilities (includes credit card liabilities)
Long-term liabilities (which includes personal loan, home loan, car loan, consumer durable loan, any loan from money lenders and any form of loan)
Let us understand this with the use of an illustration:
Assuming your total assets are Rs 1.5 crore and your total liabilities at Rs 20 lakh, your total net worth would be Rs 1.3 crore (Rs 1.5 crore less Rs 20 lakh).
So your solvency ratio would be 130,00,000/1,50,00,000 *100 = 86.67 percent.
But is it good?
Yes. The ideal solvency ratio should be at least 50 percent. Anything less than 50 per cent would lead to financial trouble in the long run.
What does it signify?
For all your debts, current and future, you are leveraging your income against those loans since it is from that income that you have to pay your loans. Not only your loan but even your daily expenses. If you cannot meet the liabilities then your other assets run the risk of running into troubled waters and you might have to sell them to pay off your liabilities.
This is the dark territory of insolvency.
Bottomline: Perform a simple personal financial ratio check on how much you can borrow and check your solvency ratio to understand your long-term solvency and stay out of financial mess.
Next week: Net invested assets to net worth
The writer is a certified financial planner and can be reached at firstname.lastname@example.org.