Financial Ratios, a rough skeleton on which a Client's Financial well being can be projected

Financial Ratios, a rough skeleton on which a Client's Financial well being can be projected

Financial planners usually on their way to create a path of financial freedom for their clients, start with the analysis of the current set of investments and the plans which the client has taken. The current financial situation is judged basis their net income and expenses, their debt, their liquid assets, liquidity, solvency, net worth, savings rate etc.Financial ratios are decision making tools which tell you how good or bad your financial health is.
For any financial plan to be made all the above ratios have to be taken into consideration. Let us have a quick look to what they actually mean:

1.Net worth ratio, simply means what is the difference between the total assets you possess and the total liabilities which stand against your name.

Net worth is not only that starting step that directs you to set a financial plan to reach your goals, but helps you to protect your assets via insurance coverage by determining the worth of your assets.

Formula: Net Worth = Total of all your assets – Total of all your liabilities

Thumb rule: Net Worth thumb rule = (Your Age x Gross Annual Income from all sources except inheritances)/10*;

   

Example: If you're 30 and earn Rs 5 lakhs a year, ideally you should have a net worth equal to or more than Rs 15 lakhs.

2.Savings ratio

The Savings ratio simply tells you how much are you saving monthly. It is not only the proportion of income which is saved, but also a measure of one's risk profile­ whether you are proactive with investments or not.

Formula: Savings Ratio = Monthly savings / Total monthly Income

Rule of thumb: There is no general rule of thumb as the amount of savings to be made depends upon an individual’s lifecycle stage. As a guideline, it can be taken as 15%-20% of monthly salary. However, the more the better.

         

Note: A single month savings ratio does not reveal much but taking an average of several monthly savings ratios will be a better indicator of how good or bad you are at saving.

   

3) Debt to income ratio

This ratio indicates the total monthly income that goes towards paying all your monthly debts (home loan, car loan, personal loan, credit card, consumer durable, gold loan etc) - all outflows towards servicing debt are taken into account here.

Formula: Debt to Income Ratio = Monthly debt payments / Total monthly Income

But just about everyone has debt. The real question how much is too much? That will again depend upon the lifecycle stage of the individual. For example, a man in his early 30s usually would be servicing more debt payments (on account of home loan, auto loan, consumer durable etc) than a person in his 50s who is nearing retirement.

    

Rule of Thumb: The lower the ratio, the better. The lower this ratio the lesser burden there is on the individual to make payments on his/her debts. High debt to income ratio also means having a low savings rates. It also threatens one’s ability to retire with the desired retirement corpus.  General guideline is a ratio of less than 40%.

      

2 more Debt ratios:

(i) Housing loan outflow Ratio – This is a parallel version of debt-income ratio used by home loan underwriters to scrutinize the creditworthiness of borrowers. You can apply this to assess your monthly housing loan liability against monthly total income.

Formula: (Home loan EMI + loan insurance + property taxes + other relevant payments) / by Total Monthly Income

Rule of Thumb: Housing loan expenses should not exceed 30% of gross monthly income.

    

(ii) Credit card debt Ratio – On similar lines of housing loan outflow ratio is credit card debt ratio. It is useful to assess credit card debt payments vis a vis total monthly income.

Formula: Monthly credit card debt payments/ Total monthly income

Rule of Thumb: This ratio should be less than 20%. A high ratio could point to excessive use of credit cards.

  

4) Debt assets to Total assets ratio

This ratio compares total debt assets to total assets to gain a general idea as to the amount of borrowed money being used by you.

Formula: Total debt assets/Total assets

Rule of thumb: A lower ratio is desirable. A low ratio means that you are less dependent on borrowed money.