Article 127 Financial Tune-Up - Part 6 Financial Ratios Can Keep One on Track
Financial ratios can keep you on track with your finances. You don’t have to compare your own financial situation with all the others as this may just discourage you from pursuing your own goal. Besides, no two people are alike. Even twins are different from each other so why should we compare ourselves with the others?
We did the debt to income ratio in Part 2 already and found out we should not go over 30% of our gross annual income to pay for our debt. Once we go over the 30% mark, we should really stop incurring anymore debt and to stop using the credit card as well. The other choice is to earn more money or find out from our budget where we can save.
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Let us do the next financial ratio which is the liquidity ratio. This is used to determine the family’s ability to pay off its debt. The higher the value of the ratio, the better is the margin of safety that the family can meet its obligations. For this, it is wise to use only the sum of cash the family has because that is the most liquid asset that can be used to pay for the monthly expenses and to pay off the short term debts in an emergency.
Here is the formula for the liquidity ratio. Liquid assets divided by monthly expenses equals liquidity ratio. Now let us apply that to our situation: Say our monthly income is $5000 a month ($60000 a year) and we have an emergency fund of $1000. Add $60000 and $1000 = $61,000 which is our liquid assets.
Our monthly expenses is $5000 so we can now calculate our liquidity ratio by following the formula: Liquidity ratio = liquid assets of $61,000 divided by monthly expenses of $5000 equals = 12.2 (The higher this amount the better it is for the family to pay for its obligations.) This is good result for the target is 3 to 6 months and our liquidity ratio is good for 12.2 months.
Now let’s go to the housing expense ratio which will let us know how much home we can afford. The formula is Monthly Housing Cost divided by Monthly Gross Income. Now let us apply this formula to real figures. Say the housing cost mortgage payment, insurance and association fees is $1000.00 and our Monthly Gross Income is $5000.00.
Now we are ready to calculate the housing expense ratio: $1000 divided by $5000 = .2 X 100 = 20%. This is not bad because the target is less than 28% which is acceptable to lenders. Sometimes they qualify the borrower who has more than 28% if the credit history is excellent.
The formula for savings ratio is Savings Per Year divided by Annual Gross Income. The other name for savings ratio is Average Propensity to Save (APS). It actually refers to the proportion of the income saved which is usually expressed for household savings as a percentage of total household disposable income.
As before, let us apply this formula to real figures. Say you were only able to save $50 a month which means a total savings of only $600 a year. So following our formula $600 divided by $60,000 = .01 X 100 = 1%. Saving only 1% a year is not good, is it? So now we know we have to do better in this area because depending on age, one is supposed to save between 8 - 25%.
The savings ratio does not remain constant, thank goodness. It changes from time to time and is different between countries. It is also affected by some factors like the number of older people who some say are not motivated to save. Inflation also can affect the savings ratio as people may want to spend money now especially on big items if they anticipate the prices will go up.
The last ratio we should really work on is the solvency ratio, the formula of which is Total Assets divided by Total Debt. We learned to do our total assets when we worked on our net worth. Incidentally, we also have our total debt there. Let us dig that up, shall we?
Here is what we did. We found the net worth by adding all the assets and liabilities. Then we deducted the total liabilities from the total assets and we found our net worth. Applying the formula to this, say you found your assets as $200,000.00 and your total debt load to be $150,000.00. Divide 200,000 by 150,000 and you get 1.33.
Since the target is 1, you are in a good position although a solvency rate of greater than 20% is considered financially healthy and you are likely to continue to meet your debt obligations. The lower the solvency rate is, the higher is the odds that the family will default on its debt obligations.
There you have now how to calculate the measurements that will help us know if we are on track with our finances. This way, if we find out we are falling behind the targets, we will know what to do to remedy the situation. We will have time to make the corrections needed before disaster strikes because we are on the right side of the financial ratios.
By Roger Guzman, M.D. and Evelyn Guzman
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Article 129 Financial Tune-Up - Part 7 Debt Reduction Plan
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