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7 ratios which will reveal your current financial health

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As you seek to improve your money management skills and make plans to strengthen your future financial position, preparing a family balance sheet would be a logical start. Balance sheet is a common tool used to analyse the net worth and expense management techniques of companies.

Adopting these corporate management techniques to manage your family's finances would help you by giving a specific direction to your thought process by identifying the weak areas.
Here are seven ratios will help you understand you current financial health better and should motivate you to take corrective actions:

1. Liquidity ratio

Liquidity ratio represents an individual's ability to meet committed expenses when faced with an emergency.

LIQUIDITY RATIO = CASH OR CASH EQUIVALENTS / MONTHLY COMMITTED EXPENSES

While some financial planners define this ratio as the ratio between liquid assets and net worth, the basic liquidity ratio (given above) is used in terms of analysing existing emergency funds. It is a prescribed practice to maintain 3-6 months of expenses as your emergency fund, which means that the ideal levels of liquidity ratio range between 3 and 6.

2. Asset to debt ratio

This ratio compares the assets accumulated by an individual against the existing liabilities.

ASSET TO DEBT RATIO = TOTAL ASSETS / TOTAL LIABILITIES

Total assets include both liquid and illiquid assets accumulated over years. Total liabilities include all forms of liabilities such as home loan, car loan, outstanding credit card balance and so on.

The ideal figure of this ratio may vary depending upon the individual's situation. For a middle-income person in his/her early thirties who has just bought a new home, this ratio is recorded lower. Similarly, for a person in his peak earning phase, the ratio is recorded higher. This ratio stands as relative measure which helps in determining what you own vs. what you owe.

3. Current ratio

This ratio represents the ability of an individual to service short-term liabilities in case of any financial emergency.

CURRENT RATIO = CASH OR CASH EQUIVALENTS / SHORT TERM LIABILITIES

Cash or cash equivalent component includes assets such as cash in hand, cash in bank and other such assets which can be liquidated immediately. Short-term liabilities include all your debt repayments that are to be made in the current year. Total EMI payments that are to be made in the current year, credit card outstanding balance and other such obligations, which are to be met in the current year, are also considered when calculating short-term liabilities.

4. Debt service ratio

This ratio defines how comfortable one is making his/her EMI payments.

DEBT SERVICE RATIO = SHORT TERM LIABILITIES / TOTAL INCOME

This ratio indicates the percentage of income being accounted for debt repayment and the percentage of income left over for other mandatory household expenses and savings. Lower the ratio, better the debt management state of an individual.

5. Saving ratio

This is one of the most common and simpler financial ratios. It compares the monthly surplus being generated by an individual against total cash inflows.

SAVING RATIO = MONTHLY SURPLUS / MONTHLY INCOME

Though the ratio looks familiar and simple, it will give you valuable insight on how well your finances are being managed. It also represents one's ability to achieve his/her future goals.

A higher saving ratio translates to better money management skills.

6. Solvency ratio

Solvency ratio compares an individual's net worth against total assets accumulated by him/her.

SOLVENCY RATIO = NET WORTH / TOTAL ASSETS

Net worth of an individual is the difference between his/her total assets and total liabilities. Net worth is positive if the accumulated assets are worth more than the liabilities. This ratio indicates the ability of an individual to repay all his/her existing debts using existing assets in case of unforeseen events.

7. Investment assets to total assets

This ratio compares liquid assets being held by an individual against the total assets accumulated.

INVESTMENT ASSETS TO TOTAL ASSETS = LIQUID ASSETS / TOTAL ASSETS

Investments in stocks, mutual funds or other such investments, which can be converted to cash easily, are considered as liquid assets. Apart from these liquid assets, total assets also include illiquid assets such as real estate or other such investments which require more time to convert to cash. One should hold at least 20 per cent of his/her total assets as liquid assets.

Conclusion

Application of ratio analysis technique provides valuable insight into specific strengths and weaknesses of a family's financial situation. Once you know your true financial health of your family, your next step should be to take corrective measures along with your financial advisor.

ArthaYantra is an integrated online personal finance company.

Disclaimer: The opinions expressed in this article are the personal opinions of the author. NDTV Profit is not responsible for the accuracy, completeness, suitability, or validity of any information on this article.

Story first published on: September 15, 2013 19:24 (IST)

Tags: Financial health, Money management, Car loan, Real estate, Wealth mangement

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