Does your money usually lie idle for quite sometime before finally you invest? Are you going overboard with your debts? Are you uncomfortable with the amount you have kept aside for emergencies?
If these questions bother you, then here's what you can do about it. You have a unique financial profile in terms of income, expenses, assets and liabilities. Work out a few financial ratios, accordingly.
The Liquidity Ratio
Liquidity Ratio = (Cash + Balance in Savings A/c, etc) / Avg monthly expenses
Liquidity Ratio essentially indicates whether you can meet emergency needs comfortably. These could include a great investment opportunity (eg the recent crash in the markets), a sudden marriage in the family, emergency hospitalisation, etc.
You must be prepared for unexpected expenses. If all your money is locked-up in long-term investments, you could incur a loss in converting them into cash. Sometimes you may not even be able to do so.
While there is no perfect number, a ratio of around three is generally considered to be okay; ie money equivalent to about three months' of your expenses should be kept handy. A lower ratio means you run a risk and too high a ratio means your money is earning less returns.
The Idle-Cash Ratio
Idle-Cash Ratio = (Cash, Balance in Savings A/c etc Emergency Corpus)/Take-home pay
Any cash lying idle (over and above what you need to keep aside for emergencies) is a lost opportunity. If this ratio is say up to around 10-15 per cent, then it's fine. But a higher ratio means you are lazy with your investments. This, in turn, means losing a chance to earn better returns on your funds. You are not making your money work efficiently for you.
In today's world of conveniences - home service, online options, automatic investing etc - this is simply not done. You need to immediately get down to the business of automating your investments as far as possible. And as soon as possible.
The Savings Ratio
Savings Ratio = Amount invested per month / Take-home pay
As life spans increase and job spans reduce, we all need to build larger retirement corpuses to take care of a higher number of non/less-productive years. The more you save, the more capital you will accumulate. That's simple logic. But too much saving, at the cost of not enjoying life today, is also bad. The idea is to get the balance right.
First, broadly work out what corpus would be sufficient for you to live comfortably from say the age of 50 to 80 if there were no other income (don't forget to factor in inflation).
Now see if your present savings ratio is sufficient to build that corpus. If yes, then you need not worry. If not, you have to tighten your wallet. However, there is a limit upto which this is possible. If, even after improving the savings ratio, there is still a shortfall expected, then you either need to increase your earnings, or have a re-look at your retirement corpus and make it more modest.
The Debt Service Coverage Ratio
Debt Service Coverage Ratio = Total loan EMIs per month / Per-month take home pay
Easy availability and low interest rates have made loans quite common. Personal loans, home loans, vehicle loans, credit card outstanding balances, etc all add-up to a quite a sizeable amount these days for many individuals.
Considering the uncertainties in life - job loss, accidents, terrorism, natural disasters, etc - it would be advisable that one doesn't go overboard with his loans.
Financial prudence demands that one's DSCR should not exceed 40-50 per cent.
Further more, ideally one should restrict oneself to loans for home or vehicles, which at least build some assets. Personal loans, credit card loans, loans for finance consumption, should ideally be avoided or at best restricted to 10-12 per cent.
Also try to become debt-free as you approach retirement.
The Solvency Ratio
Solvency Ratio = Total Assets / Total Loan and other liabilities
If tomorrow you were asked to pay-off all your loans by selling your assets, would you be able to do it (assuming, of course, that every asset is readily convertible into cash)? If yes, you will not become bankrupt. If no, then you are living dangerously.
A solvency ratio of 1.5 or more is comfortable as it can withstand any fall in the value of your assets. Also, it leaves you with a cushion to borrow some more if required.
Solvency ratio of 1 or below is extremely risky and you must take immediate steps to reduce your debt levels.
Once you calculate these ratios, you can judge for yourself whether you are financially healthy or not. Accordingly, you can take the proper corrective action(s), if need be.
Sanjay Matai, is an investment advisor.
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