Before we start learning the important ratios or indicators of financial health, I promise I won’t bombard you with mathematical concepts or explain theorems. This will involve some basic calculations using addition, subtraction, multiplication and division and nothing more than that.
If you have observed a pathological report, you will note the last column which says “Healthy Range”. This is the range where the test report observation should be of a healthy person. A reading above or below is an alarm for the doctor to decide your future medication. For us, as your financial health keepers the ratios are similar to the medical tests that doctor prescribes when you show symptoms of illness. We carry out these tests or calculate ratios to know your present condition and your future prospects.
The figures used in these test are Income, Expenses, Assets and Liabilities. Each of the ratios is the interplay of these basic elements and when put to the test (when the ratios are derived and matched with what they should be), can open up a lot of hidden mysteries of one’s financial life. Let’s see how this is done applying some BASIC RATIO TESTS:
So we start with The First Test– Savings Ratio or Expense Ratio
Savings Ratio or Savings to Income Ratio determines what part of income a person is saving, as this saving can be invested for fulfilling his mid and long term goals.
| So if a Ram aged 40, is earning Rs 6 Lakhs a year and saves around Rs 60000/- his Savings Ratio is 10%. |
| (60000/6000000 multiply by 100). |
Savings=Retained income after expenses plus all money received from previous investments (eg savings bank interest or dividends from investments in mutual funds etc.).
Alternatively, Expense Ratio or Expense to Income Ratio is the opposite of Savings Ratio. It determines what a person is incurring as recurring expenses for that year. So for above example the expense ratio is 90% (554000/600000 multiply by 100).
Significance: These ratios measure the preparedness to meet long-term goals like retirement. The appropriate level of this ratio depends on the age of the person as in the early thirties and forties a person has more expenses and is likely to be servicing loans to accumulate assets like home or car. So to start from 20% from young age and going to 50% during early retirement days is a healthy sign. Clearly Ram in the above example will have a tough time ahead.
The Second Test – Leverage Ratio
In today’s scenario, it is likely that a person has acquired some assets through loans or savings and also he may be servicing some loans used to make large purchases like house or durables or he may be financing a larger expense like an education loan etc. So at a time a person should know if his assets are over his liabilities or he is in risk zone of servicing high liabilities.
So Leverage Ratio = Total Liabilities/Total Assets.
| So Ram discloses that he owns real estate worth Rs 50 lakhs, which was bought for Rs 30 lakhs loan and still Rs 10 lakh of loan is pending. Also, he has investments and bank balance worth Rs 10 lakh and Rs 5 lakhs in PPF. He has credit card dues of Rs 1 lakhs and has to repay 1 lakh to his friend which he took as a loan.
Ram’s Assets: Rs 50 lakhs + Rs 10 lakhs + Rs 5 lakhs = Rs 65 lakhs Ram’s Liabilities: Rs 10 lakhs + Rs 2 lakhs + Rs 1 lakhs = Rs 13 lakhs |
| Leverage Ratio= Rs 13 lakhs/Rs 65 lakhs multiply by 100= 20% |
Significance: If your liabilities are more than assets it is alarming (Ratio above 100%). If the person is not adequately insured, in the case of death or incapacity, the person shall be in debt or the survivors will have to service the debts. This ratio is likely to be immediately high after a larger purchase. So it is a measure to see the debt servicing capability of a person.
The Third Test – Net Worth Test
A person may have assets of 1 Cr made from loans of 90 lakhs. This cannot be a good situation. It is important to check the Net worth of the person over a period of time. Also, all liabilities are not bad as they help to build assets which provide future revenues and valuation. So the financial position is measured using Net Worth Statement. This is not a ratio, but a figure to be compared over years.
Net Worth = Total Assets – Total Liabilities
| So in case of Ram, his Net worth = Rs 65 lakhs – Rs 13 lakhs = Rs 52 lakhs |
The Fourth Test – Solvency Ratio
A person can be insolvent despite having a good amount of assets. If the liabilities are high he will have a negative net worth. The extent of person’s can be calculated through his Solvency Ratio,
Solvency Ratio = Net worth Divided By Total Assets
| Ram’s Solvency Ratio will be his Net worth / Total assets
Rs 52 lakhs/Rs 65 lakhs multiply 100 = 80% |
Significance: The ratio measures the percentage of your Total assets to Net worth. As in the case of corporations, this ratio explains the quality of assets a person has and the cost, fixed or recurring, behind the accumulation of these assets. You can well imagine why will a bank or institution like to engage with you in case your position is insolvent.
These 4 basic and broad test are used to assess the present financial position of a person. Try for yourself and you will have eye-opening results. In the next post, I shall take you through the Ratios which indicate future potential and preparedness to plan/meet life goals. These will be more intrinsic and personal in nature.
I have tried to be as basic I can and hope you are not feeling heavy!!! A simple paper, pen, and calculator- is all you need to calculate these figures for yourself or a friend. Next post will have deeper insights, I promise. Till then keep sharing your views in the comments section.
