Just as a company is analyzed using financial ratios based on revenue, expenses, and debt, the financial stability of individuals or families is done using income, savings, and loans. These ratios help individuals and families evaluate current financial status, identify the financial needs and plan cash flows over time.
Types of ratios
Financial ratios can be categorized as:
- Reserves to Income
- Debt to Income
- Savings rate to Income
- Liquidity
- Debt
- Risk Exposure
- Net worth
Though there are no defined ideal values for these ratios, there is an accepted range for them. They are influenced by factors such as age, income, your family’s financial status, or general economic condition.
Calculation and Interpretation
Reserve to Income Ratio:
This ratio is calculated by dividing your current investment assets by your annual salary.
Example: A person has a total of Rs 24 lakh invested - Rs 10 lakh in his PF account, Rs 6 lakh in PPF, Rs 8 lakh in a well diversified debt-heavy mutual fund. His annual income is 12 lakh per annum. His reserve to income ratio will be Rs 24 lakh / Rs 12 lakh = 2. As a thumb rule, a person of 40 years and more should have this ratio at 3 to 5. For people below 40 it can range from 1 to 3.
Debt to Income:
Debt to income ratio tells you how stable your credit situation is. This is calculated by dividing debt by income.
Example: A person has Rs 30 lakh debt outstanding on his home and Rs 6 lakh on his car. His annual income is Rs 12 lakh. The debt to income ratio will be Rs 36 lakh / Rs 12 lakh = 3. Whether this is good or not will depend on your annual obligation. If you are paying 40-50 per cent of your income in servicing debt, you should reduce it.
Savings rate to Income:
This shows how much you save from your income every month.
Example: If the annual salary is Rs 12 lakh and contribution towards PF being Rs 1.40 lakh (including company’s contribution), Rs 60,000 towards PPF, Rs 1 lakh in a debt fund, and Rs 1 lakh in fixed deposit, totaling Rs 4 lakh. His savings rate will be Rs 4 lakh / Rs 12 lakh = 33.33 per cent. As a thumb rule, a person in his 30s should save at least 20 per cent of his salary.
Liquidity Ratio:
Liquidity ratio has two ratios, one basic liquidity ratio and second, expanded liquidity ratio.
Basic liquidity ratio:
This ratio tells you how many months you can survive without earning any income.
Example: A person has Rs 1 lakh in his savings account, Rs 60,000 in his current account, and Rs 2 lakh in his flexible account (part of savings account that is transferred to FD), totaling Rs 3.6 lakh His monthly expense is Rs 60,000. His basic liquidity ratio will; be Rs 3.6 lakh / Rs 60,000 = 6. This means the person can survive for 6 months without earning any money if these levels are not exceeded. Usually this ratio should be between 6 and 12 to meet emergencies such as job losses or long leave because of circumstances.
Expanded liquidity ratio:
In addition to basic liquidity, if you add other financial assets such as stock investments, FD, or bond investment to the liquid asset and divide by monthly income, you get expanded liquidity ratio.
Example: Let the basic liquidity be Rs 3.6 lakh and expenses be Rs 60,000 as in the previous example. If your other assets are Rs 1 lakh in equity, and Rs 1.4 lakh in FD, your expanded liquidity ratio will be (Rs 3.6 lakh + Rs 2.4 lakh)/ Rs 60,000 = 10. You can survive 10 months without earning anything.
Debt Ratio:
This includes two ratios, namely liquid asset coverage ratio and solvency ratio.
Liquid asset coverage ratio is your liquid assets divided by your debt. The solvency ratio is your all assets divided by total debt. These ratios tell you whether you have enough assets to pay off your loan.
Example: As shown in liquidity ratio example, your liquid asset is Rs 3.6 lakh and total asset is Rs 6 lakh. Suppose you have outstanding debt of Rs 36 lakh. The liquid asset coverage ratio will be Rs 3.6 lakh / Rs 36 lakh = 0.1 and solvency ratio will be Rs 6 lakh / Rs 36 lakh = 0.17. Solvency ratio should be at least 1 for people above 40 and between 0.3 to 1 for those below 40.
Risk exposure ratio:
It measures whether you have adequate insurance coverage and assets to help your family in case your earning is not available.
Example: A person has income Rs 12 lakh and has Rs 20 lakh worth assets and he has taken an insurance of Rs 1 crore. His life insurance coverage ratio will be Rs 1.2 crore / Rs 12 lakh = 10. This means his family can survive for 10 years without changing lifestyle. Of course the real number will be high as the expenses will be lower than the salary.
Net worth ratio:
Net worth is calculated by subtracting your liabilities from your assets. This tells you what your finances are worth.
Example: A person has Rs 20 lakh in government bonds, Rs 20 lakh in PPF, Rs 10 lakh in fixed deposits, Rs 2 lakh in savings account, and Rs 10 lakh in mutual funds. He has outstanding loan of Rs 20 lakh on his home. His net worth will be Rs 62 lakh - Rs 20 lakh = Rs 42 lakh
You also have to see what the growth rate of your net worth is. Suppose Rs 42 lakh is the net worth this year and your net worth last year was Rs 40 lakh. The rate of growth of net worth is Rs 2 lakh / Rs 40 lakh = 5 per cent. If the inflation is more than 5 per cent, your net worth is actually going down.
Financial ratios help you quantify the status of your financial standing utilizing simple numbers. Use these ratios to evaluate your financial situation and make it better.
Source - Financial Express
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