The personal financial situation of an individual or household is predominantly focused on effectively managing both current and future needs and expenses.
Sources of income can include salaries, business profits, or funds from saved and invested assets.
Assets are generally cultivated to address future expenses, with financial planning allocating current income between immediate necessities and savings.
Loans can bridge income gaps, allowing for expense coverage and asset creation, which will later transform into liabilities that need repayment.
The effectiveness of a household in managing income, expenses, assets, and liabilities significantly influences its overall financial condition.
To assess your financial health, several personal finance ratios can be utilized. These ratios, derived from income, expenses, savings, and investments, offer a numerical overview of your current situation, helping to inform necessary adjustments and future financial planning decisions.
1. Savings Ratio
The Savings Ratio indicates the percentage of annual income that an individual can save, calculated by dividing yearly savings by annual income.
For example, if your annual income is Rs. 60 lakhs and you save Rs. 6,00,000, the savings ratio would be Rs. 600,000 ÷ Rs. 60,00,000 = 10%.
Savings encompass more than just the funds in a savings account. Investments in fixed deposits, mutual funds, stocks, debentures, public provident funds, national savings certificates, post office deposits, real estate, gold, and other assets also contribute to overall savings throughout the year.
Some savings may not be immediately accessible to the investor within the year. For example, contributions made by the employer to the investor's provident or superannuation fund are not readily available. However, these funds belong to the investor and are recorded in their provident or superannuation account, thus contributing to that year's savings.
Annual income includes all earnings from employment or business, as well as interest, dividends, rent, and other sources accumulated over the year.
The ideal savings ratio varies depending on an individual's age. In younger years, expenses often exceed income, leading to lower savings. During this time, a significant portion of any extra income may be allocated to home loan repayments.
As time progresses and income increases while expenses become more manageable, this ratio is expected to improve.
By the early 40s, a recommended savings-to-income ratio is at least three times the annual income.
This suggests that as income grows, the annual savings rate should also rise, ensuring that savings are in line with the individual's age and life stage.
2. Expenses Ratio
The Expenses Ratio is determined by dividing Annual Recurring Expenses by Annual Income.
You can also calculate the Expenses Ratio using the formula: 1 – Savings Ratio. In the same way, the Savings Ratio can be found by using the equation: 1 – Expenses Ratio.
It's important to note that non-recurring expenses are not included in the expense ratio. For example, a one-time medical expense of Rs. 50,000 incurred in a year will not be considered.
However, if a family regularly spends Rs. 30,000 annually on healthcare (excluding any reimbursements), this amount will be included in the expense ratio calculation.
For instance, if a family takes an international vacation every three years at a cost of Rs. 6,00,000, the yearly equivalent of Rs. 2,00,000 will be factored into the expense ratio.
Mandatory expenses include taxes, rent, loan EMIs, and essential living costs. In contrast, discretionary expenses involve non-essential items. To enhance the savings ratio, most cost-cutting and adjustments should focus on discretionary spending.
Maintaining a low expense ratio alongside a high savings ratio is essential for ensuring an individual's financial security and stability.
Total Assets
Individuals invest their savings in a variety of physical and financial assets, including shares, debentures, mutual funds, real estate, gold, provident funds, superannuation funds, and more, over time. The current value of these investments represents the total assets of the investor. Typically, physical assets like real estate are purchased using a mix of savings and loans.
A cautious approach would be to exclude personal items such as jewellery, the primary residence occupied by the investor's family, and any other assets intended for personal use (e.g., a car) when assessing the assets available to achieve financial goals and meet needs.
Total Liabilities
Liabilities encompass loans and various forms of credit utilized to cover expenses or acquire assets. These can originate from institutional sources, including banks and financial institutions, or from personal sources like friends and family. Liabilities can be categorized as long-term and secured by assets, such as mortgages for purchasing a house and car loans. Alternatively, they can be short-term and unsecured, including outstanding credit card balances and personal loans, which tend to incur higher costs.
Liabilities represent a commitment to repay the borrowed amount using future income. This obligation can affect a household's ability to manage other expenses and save for additional assets. It's crucial to approach liabilities with care, ideally using them to acquire appreciating assets. The greater the liability, the more financial strain it places on the investor for repayment.
3. Leverage Ratio
This metric assesses the impact of debt on an investor's asset accumulation and is calculated by dividing Total Liabilities by Total Assets.
For instance, suppose an investor possesses real estate valued at Rs. 50 lakhs, along with investments and bank balances totalling Rs. 10 lakhs, and Rs. 5 lakhs in a provident fund account.
The real estate was acquired with a loan of Rs. 30 lakhs, of which Rs. 10 lakhs remains outstanding. Additionally, the investor has credit card debts amounting to Rs. 2 lakhs and a personal loan of Rs. 1 lakh from a friend.
Total assets = Rs. 50 lakhs + Rs. 10 lakhs + Rs. 5 lakhs = Rs. 65 lakhs.
Total liabilities = Rs. 10 lakhs + Rs. 2 lakhs + Rs. 1 lakh = Rs. 13 lakhs.
Leverage Ratio = Rs. 13 lakhs ÷ Rs. 65 lakhs = 20%.
A higher leverage ratio indicates increased risk to the individual's financial health. A ratio exceeding 1 suggests that the assets may not be sufficient to cover the liabilities. This ratio is often elevated right after acquiring a significant asset, like real estate, financed through debt.
However, as the asset appreciates in value over time, the ratio is likely to improve. Investors should evaluate leverage in relation to their ability to service debt, ensuring that risky investment positions are not further exacerbated by high leverage.
4. Net Worth
A robust asset position holds little value if most of those assets are funded by outstanding loans. Conversely, having liabilities isn't necessarily negative if they are used to acquire appreciating assets, like real estate.
Therefore, it is common practice to assess an investor's financial standing through net worth, which is calculated as Total Assets minus Total Liabilities.
In the previous example:
Net worth = Rs. 65 lakhs – Rs. 13 lakhs, which equals Rs. 52 lakhs.
Monitoring net worth over time is essential to track improvements or declines in financial health.
5. Solvency Ratio
Even if a person possesses assets, they may still face insolvency if their liabilities exceed the value of those assets. A crucial indicator is that the individual's net worth must be positive.
The level of an investor's solvency can be assessed using the solvency ratio, which is determined by the formula: Net Worth ÷ Total Assets. For the same asset value, a higher solvency ratio indicates a stronger financial standing for the investor.
For instance, in the example provided, the calculation is Rs. 52 lakhs ÷ Rs. 65 lakhs, resulting in a solvency ratio of 80%.
Additionally, the solvency ratio can also be derived using the formula: 1 – Leverage Ratio. Conversely, the Leverage Ratio can be calculated as 1 – Solvency Ratio.
Liquid Assets
Liquid assets are those that can be swiftly converted into cash to cover expenses or emergencies. Examples of liquid assets include funds in savings accounts, fixed deposits maturing within six months, investments in liquid funds or other mutual funds, and other short-term assets. Conversely, some assets are not easily convertible into cash; for instance, selling real estate at fair market value can be a lengthy process.
The more an investor holds in liquid assets, the lower the risk of facing a liquidity crunch. However, keeping all funds in liquid assets is not a wise approach. Liquidity often comes with a cost; for example, banks typically offer lower interest rates on short-term fixed deposits, and liquid schemes may yield less than longer-term debt schemes.
Investors should therefore find a balance between liquidity and returns. Maintain sufficient liquid assets to satisfy immediate liquidity needs, while investing the remainder in longer-term assets to achieve superior returns.
6. Liquidity Ratio
Liquid assets play a crucial role in addressing an individual's near-term liquidity requirements.
Typically, liquidity needs are calculated based on the expenses an investor is expected to incur over the next six months, including loan repayments. In rare cases, expenses over a longer duration may also be taken into account.
The liquidity ratio assesses how well a household can cover its expenses using short-term assets. It is determined by the formula: Liquid Assets / Monthly Expenses.
A ratio between 4 and 6 suggests that a household is in a comfortable position to meet its expenses for four to six months, even in the event of a loss or decrease in regular income.
Let’s examine a financial scenario. Monthly expenses Rs.1.5 lakh, including loan repayments.
The market value of the assets held is as follows:
· Equity Shares: Rs.3 lakhs
· Savings Bank Account: Rs.7 lakhs
· Short-term Fixed Deposits: Rs.2 lakhs
· Long-term Fixed Deposits: Rs.6 lakhs
· Open-end Liquid Mutual Fund Schemes: Rs.4 lakhs
· Other Open-end Mutual Fund Schemes: Rs.5 lakhs
· Closed-end Mutual Fund Schemes: Rs.12 lakhs
Calculating the liquid assets: Rs.7 lakhs + Rs.2 lakhs + Rs.4 lakhs = Rs.13 lakhs.
The liquidity ratio is calculated as follows: Rs.13 lakhs ÷ Rs.1.5 lakhs = 8.66.
A ratio around 6 reflects a secure ability to manage short-term obligations.
Note: Equity shares are excluded from liquid assets due to their value uncertainty, which poses a risk for investors.
7. Financial Assets Ratio
Assets can generally be divided into two categories: financial assets, which include shares, debentures, bank deposits, Public Provident Fund, mutual fund investments, and others; and physical assets, such as gold, other precious metals, diamonds, and real estate. Financial assets offer advantages such as higher liquidity, flexibility, convenience in investing, and ease of management. They primarily serve as income-generating investments, although some, like equity-oriented investments, are held for long-term capital growth. Investing in financial assets is more accessible, allowing for smaller and more frequent investments.
Let's take a look at the assets:
Shares: Rs. 5 lakhs
Fixed Deposits: Rs. 10 lakhs
Mutual Fund Investments: Rs. 12 lakhs
Land: Rs. 9 lakhs
Gold: Rs. 14 lakhs
Financial assets total Rs. 27 lakhs (5 + 10 + 12).
Physical assets amount to Rs. 23 lakhs (9 + 14).
Overall, total assets equal Rs. 50 lakhs (27 + 23).
The financial assets ratio is calculated as follows: [(Rs. 27 lakhs ÷ Rs. 50 lakhs) * 100] = 54%.
A higher percentage of financial assets is generally favoured, particularly as goals approach realization and when there is a need for income or funds to achieve those goals.
8. Debt to Income Ratio
Leverage ratio indicates the extent to which debt is utilized in acquiring assets. However, it does not directly assess an individual's income's capacity to service or fulfill the obligations arising from all outstanding debt. The debt-to-income ratio serves as a measure of one's ability to manage current commitments based on available income and is a criterion used by lenders to evaluate eligibility for additional loans.
This ratio is calculated using the formula: Monthly Debt Servicing Commitment ÷ Monthly Income.
Debt servicing encompasses all payments owed to lenders, whether for principal or interest.
For instance, consider an individual with a monthly income of Rs. 1.5 lakh and loan commitments amounting to Rs. 60,000 per month. The Debt to Income ratio would be Rs. 60,000/Rs. 150,000 = 40%.
A ratio exceeding 35% to 40% is regarded as excessive. This indicates that a significant portion of the household's income is allocated to meet these obligations, potentially impacting their ability to cover regular expenses and save.
Obtaining loans in the event of an emergency may also become challenging. Any reduction in income will create stress on the household’s finances.
All of these ratios provide insight into your financial status. The emphasis should be on identifying the ratios that are lacking and working to enhance them over time.
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