Four financial ratios you must know
If you fall short on any of these ratios, it’s time to review your savings and expenses. Here’s what
they are and how to calculate them you jog every day, eat healthy food and avoid too much
stress. You feel absolutely fit and would never suspect anything can go wrong with you. But
during one of the health check-ups, which you go for as part of your healthy lifestyle regimen,
the doctor told you your blood pressure has shot up to 160:100 instead of the usual 120:80. You
make amends and get it under control in a week or two.Just as maintaining a particular ratio is
important for your blood pressure, there are certain ratios you need to maintain for your financial
health, too. On the face of it, your finances may seem in order, but a closer look may reveal it
needs special attention at times. Here are four important ratios you must maintain to keep your
financial life in order.
What is it: This ratio tells you whether you will be able to meet emergency needs with ease. It
gives the number of months you will be able to meet your regular expenses in case your income
stops suddenly due to, say, a job loss or a medical condition or disability.How to calculate it:
Divide your liquid assets by your monthly expenses.
Your liquid assets would include any cash that you may have stashed away in your savings bank
accounts or elsewhere, or savings in fixed deposits or liquid funds. Usually, financial planners say
that the money you have invested in equities or equity mutual funds shouldn’t be part of your liquid
assets since the returns from these instruments are subject to market movement.To calculate your
monthly expenses, you will have to take into account rent, equated monthly instalments (EMIs), if
any, insurance premiums, besides living and lifestyle expenses. Once you’ve the two figures, divide
the amount of liquid assets with your monthly expenses to get your liquidity ratio. For instance, if
your liquid assets are worth Rs. 2 lakh and you spend around Rs. 1 lakh, your liquidity ratio is two
divided by one, which comes to two. Which simply means that you will have two months of
expenses available in case your income stops suddenly.How much is enough: As per most
financial planners, this ratio should be 3-6. In fact, the higher the figure, the more liquidity you
have. If your liquidity ratio is say eight, then it means that you will have enough liquid assets to
meet your current monthly expenses for the next eight months. As a general thumb rule, a ratio of
3-6 is good, but this ratio changes with your age, income and financial situation. For instance, for
someone who has a large income but relatively smaller average monthly expenses, a lower ratio
number would work. But someone who has irregular income flow, a higher ratio number becomes
mandatory. A person with a ratio less than two is definitely in the danger zone and needs to take
some financial discipline measures right away.
What is it: One of the most important ratios from the financial planning point of view, this ratio
tells you whether you are saving enough for your future.It is basically the proportion of income you
set aside as savings and is expressed in percentage terms. How to calculate it: To reach this
number, divide your savings per month by your net income per month. For instance, if you are
saving Rs. 10,000 a month and your income is Rs. 1 lakh per month, your savings ratio is Rs. 10,000
divided by Rs. 100,000, which comes to 10%. This means you manage to save 10% of your
income.How much is enough: Generally, an individual should have a savings ratio of at least
10%, but most financial planners recommend that your savings ratio should be as high as
possible.Of course, this ratio changes as per your age, life cycle, income and individual
circumstances. Says Suresh Sadagopan, financial planner, Ladder7 Financial Advisories: “If you are
in your 30s, you need to have a ratio of 5-10%, considering that you may have higher number of
loans to service and more lifestyle expenses. In early 40s, it should be 25%. By 45, it must be
30%, considering that your income would have increased substantially by then. By 50 years, it
should be well above 30% since by then you would have paid off most of your loans. Above the age
of 50, your savings ratio should be as high as possible.” If your savings ratio drops below 5%, your
financial future could get in some serious jeopardy. So, act now.
What is it: This ratio is the portion of your income that goes to repay your debts and shows you
how far are you from a debt trap.How to calculate it: Divide your total EMIs on all your loans and
debts by your total monthly income to get this ratio. For instance, your home loan EMI is Rs.
12,000, car loan EMI Rs. 5,000, personal loan EMI Rs. 3,000 a month and a credit card minimum due
payment of Rs. 5,000, your total debt stands at Rs. 25,000. If your salary is Rs. 50,000, the debt-
service ratio would be 25,000 divided by 50,000, which is 50%. In other words, half your salary
goes into paying your EMIs and debts.How much is enough: Conservative planners believe that
your debt service ratio should be 30-35%. Therefore, of every Rs. 100 you earn, Rs. 35 should go
into servicing loans. But in today’s times, it is difficult to survive without taking loans. Keeping that
in mind, many planners suggest that this ratio could be higher. Ranjit Dani, Nagpur-based certified
financial planner says, “Debt-service ratio should be around 40-45%.” Anything more than that
means you are in a vicious debt trap. Again this is a general number. Someone with a very high
net-worth may afford to have a slightly higher ratio compared with someone with a lower income.
What is it: This gives you the level of debt you are into in relation with your assets.How to
calculate it: Divide your total liabilities by the total assets you may have. It is expressed in
percentage terms. For instance, if your total liabilities is Rs. 7 lakh and the value of your total asset
is Rs. 10 lakh, your leverage ratio is 70%.How much is enough: Your leverage ratio should never
be more than 50%. Say if your leverage ratio is 70%, it tells you that 70% of your assets are
currently financed by debt. A high ratio is a dangerous since any increase in interest rates may get
you in a tight spot. There are many more ratios, you could refer to, but the ones mentioned here
will pretty much let you know how you are doing financially. If you think you are falling short on any
of these, it’s time for a financial work-out.
Your financial life is OK when
Your job is to keep the fantastic stories of multiplier returns and land deals of your peer group from
pushing you to make rash movesThe answer lies in building a grid that is robust and then allowing it
to play out. Your job is to keep the fantastic stories of multiplier returns and land deals of your peer
group from pushing you to make rash moves. If we can do this—keep our own expectations in
check; there is a set of rules that will ensure basic financial hygiene. You’re doing OK if you are
doing the following things.
You’re doing OK if you are getting a full 12% of your basic deducted towards your Employees’
Provident Fund. This ensures that the employer is pulling in 12% as well into your retirement fund.
One calculation says that somebody who begins work in early 20s at Rs20,000 a month salary and
sees a 10% increment each year, will end his career at 60 years of age with a provident fund (PF)
corpus of Rs2.6 crore. Most of us have fragmented earning lives due to job changes or breaks in
career (specially true for women) and don’t allow PF to build up. To get the best of this tax-free
government largesse, just don’t break your PF thread. Don’t withdraw, allow it to grow. In addition,
if you are contributing the full Rs70,000 to your PPF account each year and not dipping into it,
you’re are doing fine.
You’re doing OK if you have a pure life insurance cover that gives between Rs25 lakh and Rs2
crore to your family in your absence. An income of Rs12 lakh a year will usually need about Rs50-70
lakh as cover. Keep adding cover for the loans you take. You’re doing OK if you top up your office
mediclaim with individual policies for self and spouse. Or if there is no office cover, individual
policies for the family topped with a floater. You’re doing OK if a household insurance policy covers
the house and its contents.
You’re doing OK if the house in which you live is fully owned or there is a property that is in your
name. In addition, if you decide to take a loan and buy another property as another real estate
investment, the math becomes a bit more complicated. It will work if the rent you get covers about
half the equated monthly instalment (EMI). It will work if the EMI can be covered easily by one
income in a two-income household. Real estate gets complicated and very specific to the person
because the ability to leverage future income differs across people, incomes and appetite for risk.
The safest way is to own the roof over your head fully. Then, as a retirement planning tool, it is fine
to buy a second property that you let out. Of course, the ability to deal with the seamier side of
India as soon as you get into any property deal is something you need to be able to stomach. Makes
me sick—but that’s another story.
You’re doing OK if you have some cash in the bank towards an emergency—think of three months
without income if you are trying to wrap your mind around the “how much” question. In addition,
notice that investment in equity is coming last after all of the above. You are doing OK if you have a
portfolio of mutual fund schemes that follow the Mint50 list of funds. You’re choosing four to six
schemes and funding them every month, never mind the boom and bust cycles.
How much should you be investing? Save your age. If you are 20 years of age, 20% of your
income is good. At 30, with no assets to your name, you need 30%. At 40 and 50, likewise. Most
people do have some asset build-up by the time they hit 35-40, so after counting in the 24% of
basic that goes into risk-free EPF, it is safe to put the incremental amount into equity funds. We
tend to make baskets of our investments and break up the monthly savings further into equity
funds and safe fixed deposits. After all of the above steps are over and you have a number that you
know you can save in addition to all the premiums, EMI, PF cuts, tax and all the rest, go solidly for
equity funds. And you’ll do OK.
Monika Halan works in the area of financial literacy and financial intermediation policy and is a
certified financial planner. She is editor, Mint Money, and can be reached at