Personal finance refers to managing the financial resources of an individual or household to ensure that current expenses are covered and sufficient savings are accumulated to meet future goals and large expenses. If the current income is insufficient, loans can be taken to cover current expenses or create assets. These loans create a liability for the individual or the household which will have to be repaid from future income. The effectiveness with which an individual or a household balances its income, expenses, assets and liabilities determines its financial situation.
Tracking various financial ratios provides individuals and households with a comprehensive view of their financial situation by comparing various elements of their financial data. Financial ratios give insight into an individual's or household's overall financial health, support informed decision making, identify areas for improvement, monitor progress, and enable comparisons with industry averages. By tracking financial ratios, individuals can gain a better understanding of their financial situation and make informed decisions about spending, saving, and investing to achieve their financial goals.
In this article we will examine various significant financial ratios that can be used to monitor the financial situation of an individual or a household.
Savings Ratio
Savings Ratio is simply the percentage of income that an individual or a household saves. It is calculated by dividing the amount saved divided by the total income.
Savings Ratio = Savings / Income
Savings would include the amounts invested in mutual funds, fixed deposits, PPF, NSC, real estate (except self occupied properties), gold, etc.
Annual income would include income from business or profession, salary, rent on property, interest on deposits, etc.
For example, Mr. Roy earns a salary of Rs. 10 lakh, receives rent of Rs. 3.6 lakh and receives interest on fixed deposits of Rs. 2.4 lakh. The total annual income of Mr. Roy would be Rs. 16 lakh (10 lakh + 3.6 lakh + 2.4 lakh). Mr. Roy has made a contribution of Rs. 1.2 lakh towards EPF, has invested Rs. 2.4 lakh in Mutual Funds during the year and has invested Rs. 1.2 lakh in fixed deposit. The total savings of Mr. Roy amounts to Rs. 4.8 lakh. Therefore Mr. Roy’s savings ratio would be 30% (4.8 lakh / 16 lakh)
Expense Ratio
Expense Ratio is the percentage of income that is spent. It is calculated by dividing the amount spent divided by the income.
Expense Ratio = Amount spent / Income
OR
Expense Ratio = 1 - Savings Ratio
Continuing the above example of Mr. Roy, the expense ratio of Mr. Roy would be 70% (1 - 30%)
Only recurring expenses are considered while calculating expense ratio. As non-recurring expenses are one time events and unpredictable they are excluded while calculating expense ratio.
Savings to Income Ratio
Savings to Income Ratio, also known as savings rate, measures the proportion of an individual's or household's income that is saved. It is calculated by dividing the total savings by total annual income.
Savings to Income Ratio = Total savings / Annual Income
For example, Mr. Roy has Rs. 12 lakhs in EPF, Rs. 24 lakhs in Mutual Funds, flat worth Rs. 40 lakhs and Rs. 20 lakhs in fixed deposits (here the value of his self-occupied house of Rs. 70 lakhs is not considered). Therefore, his total savings are Rs. 96 lakhs. His total annual income is Rs. 16 lakhs. Therefore, his savings ratio is 6.
The Savings to Income Ratio is helpful in determining the level of preparedness of an individual or a household to meet its long-term goals. The total savings are calculated by considering the current value of investments and assets. It is necessary to deduct any amount of loan outstanding while calculating the savings and also to exclude self-occupied property.
The appropriate level of Savings to Income Ratio varies depending on the age of the investor. Generally, young investors would have a low Savings to Income Ratio and a significant part of their income would go towards paying home loan EMI. Over time, this ratio would improve as the individual’s income would increase and payment towards debt would reduce. It would be ideal for someone in their 40s to have a Savings to Income ratio or 3 times the annual income.
Leverage Ratio
Leverage Ratio measures the extent to which an individual or household is using debt to finance their assets. It is calculated by dividing total liabilities by total assets.
Leverage Ratio = Total Liabilities / Total Assets
Example, Mr. Shah owns a property worth Rs. 75 lakhs which he had purchased for Rs. 60 lakhs 5 years ago and has Rs. 25 lakhs loan outstanding against the property. He has Rs. 10 lakhs in EPF account, Rs. 5 lakhs in mutual funds and Rs. 2 lakhs in fixed deposits. The Leverage Ratio of Mr. Shah would be 27.17% (25 lakh / (75 lakh + 10 lakh + 5 lakh + 2 lakhs).
A high Leverage Ratio indicates that an individual or household has a large amount of debt relative to their assets, while a low leverage ratio indicates they have less debt. A Leverage Ratio greater than 100% indicates that the liabilities outweigh the assets and is a warning sign of excessive debt. The ratio is likely to be high on purchase of a major asset such as a home with a loan. The ratio will become more balanced as the loan is repaid over time and the value of the asset appreciates.
Riskier investments should not be financed through a high amount of debt. This increases the level of risk because if the investment does not do well, the individual may not be able to repay the debt, leading to financial difficulties. For example, investing in futures and options by itself is risky because of its speculative nature, the risk is further enhanced if the investment is made by availing a high cost personal loan. In other words, high leverage financing can make an uncertain investment even more hazardous.
Net Worth
Net worth represents an individual's or a household’s financial standing. It is calculated by subtracting the individual's liabilities from his assets.
Net Worth = Total Assets - Total Liabilities
Net worth is used to track an individual’s financial progress and evaluate the effectiveness of their financial plan and financial decision. An improvement in the financial position of an individual can be indicated by an increase in their net worth, while a decrease in net worth signifies a decline in their financial situation. Therefore, a person with many assets obtained through loans would not have a high net worth and cannot be considered financially secure.
Continuing the above example, Mr. Shah’s Net worth is Rs. 67 lakhs (75 lakh + 10 lakh + 5 lakh + 2 lakh - 25 lakh)
Solvency Ratio
Solvency Ratio measures the ability of a person or a household to meet their long-term financial obligations using their current assets. Solvency ratio is calculated by dividing the net worth by total assets.
Solvency Ratio = Net worth / Total Assets
An individual with a high solvency ratio is considered to be in a strong financial position and can repay debts easily. Therefore, a person having many assets could be insolvent if these assets are financed through loans and he is unable to repay the loans.
Solvency ratio can also be calculated as 1 - Leverage ratio.
Continuing Mr. Shah’s example, his solvency ratio is 72.83% (67 lakh / 92 lakh or 1 - 27.17%)
Liquidity Ratio
Liquidity ratio measures the individual’s or the household’s ability to meet its short-term obligations from its liquid assets. Liquid assets are those assets which can be converted into cash within a short period of time, usually within 1 business day. Examples of liquid assets include cash, amount in savings account, investment in money market or liquid funds, etc. Liquidity ratio indicates the amount of readily available funds to pay off debts and expenses in the near future. A high liquidity ratio helps ensure that an individual or a household can meet unexpected expenses or emergencies without difficulties. Liquidity ratio is calculated by dividing liquid assets by monthly expenses.
Liquidity Ratio = Liquid Assets / Monthly expenses
It is desirable to have a liquidity ratio of 4 to 6, this indicates that the individual or the household has sufficient funds to cover its expenses for 4 to 6 months in the event of a loss or decrease in regular income.
Consider the investments of Ms. Rani, Rs. 50 thousand in her savings account, equity shares of Rs. 5 lakh, long-term fixed deposit Rs. 10 lakh, real estate of Rs. 50 lakhs, investment in mutual funds of Rs. 20 lakh out of which 3 lakh is in money market funds. The total liquid assets of Mr. Rani amounts to Rs. 3.50 lakh. Monthly expenses of Ms. Rani amounts to Rs. 75 thousand. Therefore, Ms. Rani has a liquidity ratio of 4.67, which is adequate. Equity shares are excluded from liquid assets because of their volatile nature and uncertainty in their value.
Debt to Income Ratio
The Debt to Income Ratio measures the individual’s or the household’s ability to meet the monthly debt obligations from monthly income. The debt to income ratio is calculated by dividing the monthly debt payment by monthly income.
Debt to Income Ratio = Monthly debt payment / Monthly income
A high Debt to Income Ratio indicates that a household has a high level of debt relative to its income, which may affect its ability to make debt payments and could increase its risk of defaulting on its loans. A low Debt to Income Ratio, on the other hand, indicates that the household has a good debt repayment capacity.
A high Debt to Income Ratio of over 35% to 40% can be problematic as it takes up a significant portion of the individual’s or the household's income to meet debt obligations, leaving little room for regular expenses and savings. Additionally, it could make it challenging to obtain loans in the case of an emergency, and even a minor decrease in income can strain the household's finances.
Conclusion
Financial ratios are used in personal finance to evaluate and track financial performance, identify areas of weakness or improvement, and make informed financial decisions. They provide a snapshot of an individual's financial position and help measure progress over time. Financial ratios should be calculated annually and compared with the past figures to identify trends.
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