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Financial position

6 simple ratios to assess financial situation and health

By August 17, 2021No Comments

In financial planning, one of the first steps is to determine a person’s current financial situation. A person’s personal financial situation refers to their ability to manage their current and future needs and expenses.

Current and future expenses are covered primarily by income (from salary / business / profession) and assets generated by saving part of the income over time. Assets are created / Savings are made to cover future milestone expenses like marriage, purchase of goods, child rearing, vacation abroad, etc.

Loans are also used to cover current / future expenses, if income / assets are insufficient. However, taking out loans means pledging a portion of future income to service the debt. It should be used with caution, ideally for acquiring assets that are appreciating in value.

The complex interplay between income, expenses, assets and liabilities and how an individual manages them determines their financial position.

There are a few ratios that are very simple to calculate and can be used to determine one’s financial position.

  1. Savings and expense rates

  2. Leverage and solvency ratio

  3. Savings / total income ratio

  4. Debt-to-income ratio

  5. Liquidity ratio (2 methods)

  6. Financial asset ratio

Illustration 1: A’s gross salary for the year is Rs 5 lakh. He receives a salary in hand of Rs 4 lakh after withholding tax (TDS) of Rs 50,000 and contribution to the contingency fund (PF) of Rs 50,000. He spends Rs 3.5 lakh per year and saves Rs 50 000 in term deposits.

In this case, A’s savings are Rs 1,000,000 (fixed deposits plus PF). A’s expenses are Rs 4,00,000 (current expenses plus income tax).

Savings rate = Savings ?? Income = 1 lakh ?? 5 lakh = 20%

Expense ratio = 1 – Savings ratio = 1 – 20% = 80% or

Expense ratio = Expenses ?? Income = 4 lakh ?? 5 lakh = 80%

The higher the savings rate, the better. There is no ideal savings rate, however it can be compared with the national savings rate of around 30%. Another variation of the savings ratio is called the savings-to-total income ratio.

Savings / total income ratio = Accumulated savings ?? Annual revenue

In the example above, if A has saved Rs 1 lakh each year for 5 years, A’s total savings are Rs 5 lakh at the end of the fifth year. For simplicity, assume that A’s income increases to Rs 7 lakh per year during this period.

Savings / total income ratio = 5 lakh ?? 7 lakh = 71% or 0.71 times

The ratio measures an individual’s readiness to achieve their long-term goals. As income increases and you get older, this ratio is likely to improve. For someone in their 40s, the general rule is that this ratio should be at least 3.

In the illustration above, assume that a few years later, A’s asset and liability position is the same.

It has a market value of Rs 40 lakh, fixed deposits of Rs 10 lakh, a PF of Rs 5 lakh and mutual funds of Rs 5 lakh. Its total assets are worth Rs 60 lakh.

He took out a loan of Rs 30 lakh to buy the house, and currently Rs 23 lakh is in arrears. His outstanding credit card is Rs 1 lakh. His total liabilities are Rs 24 lakh.

Leverage ratio = Total liabilities ?? Total assets = 24 lakh ?? 60 lakh = 40% or 0.4 times

The lower the leverage ratio, the better. A ratio greater than 1 shows that the assets are not sufficient to meet the liabilities and that the person is insolvent. A strong asset position is of no use if most of it is acquired through loans.

Net worth is one of the most common metrics used to monitor an individual’s financial situation. It must be positive and not negative.

Net value = Total assets – Total liabilities = 60 lakh – 24 lakh = 36 lakh

Solvency ratio = net worth ?? Total assets = 36 lakh ?? 60 lakh = 60% or 0.6 times; Where

Solvency ratio = 1 – Leverage ratio = 1 – 0.4 = 0.6

The solvency ratio more than the leverage ratio denotes a very comfortable financial situation.

In the illustration above, A’s income has increased to Rs 7 lakh per year. For simplicity, suppose that the income tax and the PF contribution remain at Rs 50,000 each. The net home salary is Rs 6 lakh per year, or Rs 50,000 per month. The house he bought has an IME of Rs 20,000 per month.

The debt-to-income ratio indicates an individual’s ability to repay or service the debt. It shows whether the income is sufficient to respond to IMEs. It includes the principal as well as the interest of the loans.

Debt-to-income ratio = Monthly debt repayment ?? Monthly Income (net) = 20,000 ÷ 50,000 = 40%

The ratio of A is within the satisfactory range. A ratio above 35% to 40% is considered excessive because it shows that a large part of household income consists of expenses incurred with little room to cover regular expenses. He points out that any reduction in income could lead to undue financial stress.

Banks usually look at this ratio when calculating the eligible loan amount. If your IME after taking out the loan is more than 40%, banks may reduce the loan amount offered. If the ratio is above 40%, it may become difficult to borrow extra money / get new loans.

Illustration 2: B has total assets of Rs 50 lakh comprising fixed assets of Rs 40 lakh (house of 35 lakh + PF of 5 lakh) and liquid assets of Rs 10 lakh (short term FD + open mutual funds). B has outstanding loans of Rs 30 lakh.

Fixed assets are those assets that cannot easily be converted to cash in an emergency. Real estate takes time to sell and in FP too, there are many formalities / conditions for premature withdrawal.

It is important to have cash in your wallet. If a high proportion is kept in liquid assets, individuals are less likely to be caught in a liquidity crisis. However, it also means that the yields could be lower, like in FD. That is why it is very important to match liquidity and return considerations.

The liquidity ratio measures how well the individual is equipped to meet monthly expenses from liquid assets. In the example above, let’s say B’s monthly expenses are Rs 1.5 lakh.

Liquidity rate = Cash ?? Monthly Expense = 10 lakh ÷ 1.5 lakh = 6.6

The role of cash is to cover the short term expenses of the individual say, 4 to 6 months. It shows how many months an individual can survive (to cover lifestyle expenses) in the event of loss of employment or income. A ratio of 6.6 indicates a comfortable liquidity position. After the pandemic, this ratio should be between 6 and 12 for more comfort.

There is another variant of the liquidity ratio.

Liquidity rate = Cash ?? Net value

In the example above, B has total assets of Rs 50 lakh and liabilities of Rs 30 lakh, his net worth is Rs 20 lakh.

Liquidity ratio = 10 lakh ?? 20 lakh = 0.5 or 50%

This ratio should be interpreted in light of the individual’s goals. If there is a longer period for the goals (> 5 years), the ratio should be low, as more savings can be deployed in assets that generate higher returns.

If there is a shorter duration (

In the example above, B has total assets of Rs 50 lakh. It includes physical assets of Rs 35 (house) and financial assets of Rs 15 lakh (PF + FD + mutual funds). Other examples of physical assets include gold, commodities, vehicles, etc. Other examples of financial assets are stocks, bonds, bonds, PPFs, etc.

Financial assets have the advantage of greater liquidity, flexibility, convenience of investment and ease of maintenance. Physical assets have security concerns, they can suffer wear and are less liquid.

Financial asset ratio = Financial Assets ?? Total assets = 15 50 = 30%

A higher proportion of financial assets is preferred, especially when goals are closer to achievement and when there is a need for income or funds to meet goals.

If after performing this exercise, an individual finds that the savings ratio is 30%, the debt ratio is between 35% and 40%, the leverage ratio is low, the solvency ratio is greater than the ratio leverage and the liquidity ratio is greater than 6, then its financial position is healthy.

According to the National Institute of Securities Markets, “Personal finance ratios should be calculated periodically, say once a year, and compared to past numbers to identify trends. They help identify areas where corrective action needs to be taken to improve the financial situation. The trends also show the effectiveness of actions already taken. Although benchmarks have been established for each of the ratios, they may need to be adapted to each individual’s situation.

So what are you waiting for? DIY is all the rage these days. Use these 6 ratios to know your financial situation.

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