Using Financial Ratios to Diagnose your Financial Health

financial ratiosIt is imperative to periodically do a financial health check-up using financial ratios to ascertain the soundness of your personal financial affairs. This diagnosis will focus on the relationship between the various components of your personal finances namely your income, expenses, debts, savings and assets.

The results from these ratios will help identify your economical strengths and weaknesses along with revealing important insights that may otherwise go unnoticed.

Financial Diagnosis Tools

So, what tools are we going to use? Want to take a guess?...Personal Financial Statements!

That’s right!

Your personal financial statements i.e. Your Net-worth and the Cashflow statements are the tools you will use to do the financial health check-up.

Lets stop there first for a moment. Have you already prepared your personal financial statements? If not, leave this page and click here to go and prepare your financial statements. When you are through, come back and we shall proceed. I will be waiting for you right here...

If you have already prepared your financial statements, lets proceed and look at the financial rations.

Key Financial Ratios

With your net-worth and cashflow statements completed, you can now find out what the numbers are telling you about your financial status. For your information, numbers don’t lie :).

The key financial ratios which you will need to keep an eye on are:

1. Net-worth (+/-)

Check your net-worth; is it positive or negative?

  • A positive net-worth means you have more assets than liabilities.
  • A negative net-worth means you have more liabilities than assets. This means if you were to sell (liquidate) all your assets and use all your savings to pay off your debts, you will still be in debt.

NOTE: You should update your net-worth statement at least every six (6) months with the aim of increasing your assets, reducing your liabilities and hence increasing your net-worth.

2. Liquidity Ratio

This financial ratio indicates the number of months in which your living expenses can be paid if an emergency arises such as a job loss or reduction of income.

  • Formula: Take your total liquid assets; divide it by your total expenses.
  • Result: If the ratio is less than one, it means, with your available liquid assets, you will not be able to pay for one month expenses. If it’s one and above, it means you can survive without an income and be able to pay for all your expenses, for the number of months indicated by the ratio.
  • Recommendation: A high liquidity ratio is desirable. i.e. 3-6 months. The more the better.

3. Current Ratio

This financial ratio indicates the ability to pay current liabilities with liquid assets.

  • Formula: Take your total liquid assets; divide it by your total current liabilities.
  • Result: If your ratio is less than one, it means you do not have enough cash to pay for your current liabilities. If its one and above, it means you can pay off your current bills and other immediate financial obligations by the number of times the ratio indicates.
  • Recommendation: A high current ratio is desirable to have; meaning you have enough cash available to pay your current bills and other immediate financial obligations.

4. Debt to Income Ratio

This financial ratio indicates how much of your income goes for debt.

Formula: Take your total monthly debt payments; divide it by your total net income.
  • Formula: Monthly or Annual debt payments divided by monthly or annual net income
  • Result: If your ratio is:

    0.3 Or less - Debt level acceptable for most people.

    0.3 – 0.4 - Debt level a little high. Corrective action needed to bring debt level down. Consider paying off or consolidating some of your debt.

    0.4 – 0.5 - Danger level. Immediate action needed before you lose control of your financial situation.

    0.5 Or More - Excessive debt level. Seek professional help.

  • Recommendation: Most financial planners recommend a debt to income ratio of less than 0.3 i.e. 30%

5. Debt Ratio

This financial ratio shows the relationship between debt and net worth.

  • Formula: Take your total debt (Liabilities); divide it by your net-worth.
  • Result: If your ratio is more than one, it means at the statement’s date, you do not have enough financial resources (assets) to pay for your all your financial obligations (liabilities). If its one, it means your debts matches your assets and after paying your debts, you remain with nothing. If it’s below one, it means you can pay off all your debts and still have some spare change.
  • Recommendation: A low debt ratio (less than one) is best.

6. Savings Ratio

This financial ratio indicates how much you are saving in relation to your income.

  • Formula: Take the total amount you have allocated each month for savings, investment, emergency fund and retirement divide it by your gross monthly income.
  • Result: If your ratio is more less than 0.1 (10%), you are saving too little. If it’s above 0.1, you are doing well. Keep it up!
  • Recommendation: Financial planners recommend monthly savings of at least 10%. The more you save, the better for you.

Liquidity

Liquidity is a measure of how able you are of paying off current financial obligations.

  • Liquid assets or current assets include all cash and cash equivalents (such as savings, checking accounts and stocks) which are more easily converted to cash. Items like your home, other real estate, jewelry, although they may increase in value over time, they can be difficult to sell quickly at full market value.
  • Current liabilities include all debts that need to be paid off within the next 12 months.

There you are! Grab your financial diagnosis tools now and do a financial health check on your finances.

When you are through, proceed to determining what's important to you and setting up your financial goals.

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