Tuesday, June 28, 2011

Using ratios to assess my financial position

If we analyze companies using financial ratios, I believe we can adopt the same concept to keep track of our financial health.



The personal financial ratios aim to serve as warning signals and help detect any deterioration in my financial position. And if situation arises, I can take any necessary actions such as altering my expenditure pattern or evaluate my goals.

Here are some ratios to use which I have classified them accordingly:

1) Solvency

Purpose - indicates the probability that an individual will become bankrupt
Equation - net worth / total assets
Implication - the higher the ratio, the stronger is my financial position
Warning bell - negative = insolvent

2) Liquidity

Purpose - measures my ability to pay off the short-term liabilities
Equation - current (liquid) assets / current liabilities
Implication - the higher the ratio, the stronger is my current financial situation
Warning bell - lower than 1.0

3) Savings

Purpose - measures the proportion of my income saved in a year
Equation - cash surplus / total annual income
Implication - 40% of my net earned income which should translate to higher ratio
Warning bell - negative = over-spending (except for one-off, big-ticket items)

4) Debt Service

Purpose - measures my ability to service loan payment in a prompt and timely fashion
Equation - total annual cash loan payment / total annual income
Implication - the smaller the ratio, the better is my ability to service the loans
Warning bell - more than 0.4 = too highly leveraged

5) Gearing

Purpose - measures how much leverage I have undertaken to acquire my assets
Equation - long-term liabilities / total assets
Implication - the higher the ratio, the higher the probability of bankruptcy
Warning bell - current cash flow can't pay off monthly loan repayment

For myself, I use the ratios monthly when I consolidate my personal financial figures (of income, expenditure, cash budget etc.)

But I do make it a point as not to get too disappointed should one of the ratios fall below the benchmark due to specific circumstances. Otherwise, we will be living in a highly regulated personal system that literally adds more stress, just like a pressure-cooker.

My objective is to keep within the framework as much as I can while focusing on my financial targets. My achievements are documented when I exceed my expectation.

How about you? Did you try the ratios? If not, go on....take 15 minutes break and do a quick calculation. See the results personally.

5 comments:

  1. How about the following?

    1. Net profit = (total income - all expenditure)/total income

    2. cash conversion cycle - how fast you convert your labor into cash (for employed) or how fast your goods turn into cash (for those selling stuff)

    Since you did it on a monthly basis, you should change some of the ratios to reflect your it monthly, otherwise how to calculate the difference between the savings from say May and June?

    I think the pt of having such exercise is to force you to get financially in shape. If you don't feel stressed when you're not performing to benchmark, you shouldn't be doing this exercise in the first place.

    ReplyDelete
  2. Hello Ken,

    Thanks for the inspiration! Since I don't "see" numbers, I think I will construct something similar but in "graphical" way instead.

    Like one of those "Dashboards" now used by management today:

    http://www.accountingweb.co.uk/files/siftmedia-accountingweb/old_microsites/pegasus/business_intelligence.html

    I think I will start with a quarterly review since I move at a slower pace.

    ReplyDelete
  3. Hi Singapore Man of Leisure

    Thanks for visiting! I agree dashboards are useful for getting visual snapshots.

    At a glance, we will get the picture easily.

    Thanks for the link.


    Cheers,
    Ken

    ReplyDelete
  4. Will try now. Although my financial situation is nowhere near good. :\ Thanks for the idea, though, would be nice to know! :)

    ___
    Cheap international calls

    ReplyDelete
  5. Thanks Jimmy for dropping by :) Good luck and all the best!

    ReplyDelete

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