If you are active in the stock market, the first thought that enters your mind when you hear the word ratio would be PE ratio, debt to equity ratio, etc., the nuances of which only a fundamental analyst can decipher. But don't give up on this article just as yet because we are not dealing with complex ratios here.
The main intention of this series is to explain to you the basics of personal financial ratio and its analyses. This will help you keep a tab on your personal finances. Unlike in company ratio analyses here you do not have to be a financial wizard to understand personal finance ratios.
Now what are personal finance ratios, you would ask.
As the name suggests these ratios deal with your personal wealth, assets or cash in hand. All the more they are extremely easy to understand. Just plain discipline of maintaining a budget and statement of assets (what you earn or have) and liabilities (what you spend or what you owe to others) will help you check your financial health.
Here is a simple guide which will help you to understand these ratios in detail.
Just as financial ratios help you in evaluating a company's financial position, personal financial ratio analyses helps you evaluate your financial position as these ratios help you track changes in your financial health.
Let us take a look as to how these ratios can help you beginning with basic solvency ratio today.
Personal financial ratios
There are six ratios which help you to do the analyses of your finances and determine your financial health. They are:
Basic solvency ratio
This ratio indicates your ability to meet monthly expenses in case of any emergency or catastrophe. It is calculated by dividing the near-term cash you have with your monthly expenses.
Basic solvency ratio = Cash / Monthly expenses (this ratio is not mentioned in percentage)
You can also call it as emergency or contingency planning ratio. This ratio helps you prepare for unforeseen problems.
Take for example, Jayant Punjabi, a 30-year-old businessman whose wife underwent an emergency gall bladder surgery at a leading city hospital last year. Despite the fact that they had adequate mediclaim to take care of exactly such an eventuality, due to some administrative problems on the day of discharge, Jayant was informed that he would have to pay in cash as the bill could not be settled as cashless.
Jayant had a tough time arranging the funds on an emergency basis. He was fortunate to have good friends and relatives who lent him the money. But not everybody have such great friends or relatives to bail them out at such short notice. I am sure no one wants to be in the same shoes as Jayant's.
Hence we have to be prepared for such situation. How? By maintaining an emergency fund!
Let's analyse how much money is enough. Here is where basic solvency ratio comes handy.
The numerator of the basic solvency ratio formula, cash (near cash), would generally comprise of the following heads:
- Savings account
- Bank fixed deposits
- Liquid funds
- Cash in hand
The above components are liquid assets which come handy at the first possible hint of financial trouble. Liquid funds can be redeemed immediately. Same goes for fixed deposits as they can be broken and liquidated immediately in case of an emergency.
Only the mandatory fixed and variable expenses are taken here for simplicity. Any entertainment expenditure should not be taken as these expenses if need can be avoided.
Mandatory fixed expenses include the money you pay for EPF/ PPF contribution, loan EMIs, insurance premium, professional license fees and rent.
Mandatory variable expenses, on the other hand, comprise of food, transportation, clothing/ personal care, medical care, utilities, education expenses and miscellaneous compulsory expenses (the above expenses can vary depending on individuals).
The total of the above divided by 12 (that is 12 months) helps you arrive at the monthly average as your variable expenditure may vary. Assuming that you have cash of Rs 60,000 and average monthly expenses of Rs 25,000 your basic solvency ratio would work out to: 60,000 / 25,000 = 2.4.
But is it good?
Not quiet. An Ideal ratio should come to 3.
What does the number 3 signify?
It means that you must have money equivalent to or at least three months of your mandatory expenses in a contingency or emergency fund.
Why just 3 months? This is because research shows that 3 months time is good enough to come out of any type of financial emergency. As people near their retirement age, they should make sure that this fund is kept up to 6 months of their mandatory expenses. The fund should be divided and kept in the form of cash, fixed deposit, or liquid fund.
This is the first part of the series on personal financial ratios. This is also the building block of a healthy financial situation. Hence first and foremost do analyses of your basic solvency ratio to check your emergency fund (especially in the current economic scenario) and once this is in place, we can move ahead to the next level and next ratio.
The writer is a certified financial planner and can be reached at firstname.lastname@example.org.