MONDAY, 12 SEPTEMBER 2011 19:40 KENDRICK CHUA / PERSONAL FINANCE
ACCOUNTANTS and stock analysts determine the overall health of a company by using different financial ratios. If we are to treat ourselves as companies and scrutinize our financial statements as well and as strict as these pundits, we will have a clearer picture of our personal finance health. These ratios can serve as a guide for us in improving our overall financial condition.
Current ratio
Current ratio answers the question, “Do I have enough liquid assets to pay off my current debts?” It is calculated by dividing the liquid assets such as cash and receivables by the short-term payables such as credit-card debts and personal loans.
Picture this: In the event your banks and creditors demanded you to pay what you owe them, do you have enough funds to do so? The ideal ratio is 2 to 1, which means you need to have P2 of cash and receivable for every P1 of debt. It can’t go lower than 1 to 1. Otherwise, you have to result to borrowing to finance the debts or sell other assets to raise the cash. The higher the number, the better it is.
If your current ratio is lower than 1, you can raise this by acquiring loans with a longer maturity or due date; or sell other assets or whatever possessions you have to raise the needed cash.
Liquidity ratio
THE liquidity ratio measures your current assets against your monthly expenses. It answers the question, “How long can my savings sustain me in case I don’t earn a single peso for some time?” Don’t think for a minute that this is a farfetched idea. Being ill, getting laid off from work, or encountering other unforeseen circumstances can easily deal our funds, not to mention our morale, a huge blow.
This ratio is calculated by dividing your current assets by your monthly expenses. Three is an ideal number; six is even better. Your savings should sustain you for the next three to six months. That should be long enough for you to get back on your feet and recover from whatever devastation you had.
If your liquidity ratio is low, you can raise this by cutting down on unnecessary expenses while living on your savings; or increasing your savings while you have the means to do so; and investing them in financial instruments or other assets that generate a stream of passive income.
Savings ratio
The savings ratio measures how good you are in saving. This is computed by dividing your savings for the year against your annual income. As a rule of thumb, a 10-percent to 20-percent savings rate is sound and what financial advisers recommend.
In the book Millionaire Next Door, authors Tomas Stanley and William Danko discovered in their 20 years of research that the millionaires they have interviewed save and invest 20 percent of their income as opposed to the national average of 5 percent. This has been the fundamental characteristics of wealthy people in general. A prodigious saver, after all, has a bigger chance of being wealthy than someone who’s not.
Just like the liquidity ratio, if your savings ratio is low, you can raise this by cutting down on expenses you can live without. If you have difficulty with 10 percent, you can start with what you’re comfortable with and gradually increase that to the level recommended.
Debt-to-income ratio
The debt-to-income ratio measures how much income you are allocating toward servicing all forms of debt, including your car and housing loans. The result should not exceed more than 30 percent of your monthly pay. Otherwise, you may end up borrowing just to pay for your other expenses since the funds apportioned for these went to paying your existing debts. At the same time, you are not increasing your savings rate and improving your savings ratio.
The logic behind the debt-to-income ratio is to go from high debt and low (or no) savings to low debt and high savings.
Solvency ratio
The solvency ratio measures your total assets against your total liabilities or debts. The difference between this ratio and the current ratio is the former includes long-term debts, including home loans, car loans and other loans maturing in more than a year.
This is computed by dividing your total assets against your total liabilities. At the very least, you should have an answer of one, which means for every peso you have in your liability column, you have another peso in your asset column to pay for it. If it falls below one, then in essence, you are insolvent.
To improve your solvency ratio, invest wisely to make the value of your assets grow even if you cannot increase your savings rate.
When we have a clear picture of our financial well-being, we can make the necessary adjustments in improving it. Influential business writer Peter Drucker once said, “What get’s measured gets managed.” When we’re able to measure our finances, we can do a better job managing them.
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Kendrick Chua is a candidate for Registered Financial Planner (RFP) designation and a Certified Investment Solicitor (CIS). He is a financial adviser for one of the leading financial institutions in the country. To learn more about the RFP program, visit www.rfp.ph or inquire at info@rfp.ph.
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