Using Financial Ratios to Diagnose your Financial Health
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!
financial statements i.e. Your Net-worth and the Cashflow
statements are the tools you will use to do the financial
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?
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
can be paid if an emergency arises such as a job loss or reduction of
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.
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
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.
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
Formula: Monthly or Annual debt payments divided
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.
action needed to bring
debt level down. Consider paying off or consolidating some of your
0.4 – 0.5 - Danger level. Immediate
needed before you lose
control of your financial situation.
0.5 Or More -
Excessive debt level.
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
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.
A low debt ratio
(less than one) is best.
6. Savings Ratio
This financial ratio indicates how much you are saving in
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 is a measure of how able you are of paying off current
Liquid assets or current assets include
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
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.