wealtharticles-financial

FINANCIAL RATIOS - Calvin Yeo, CFP, MBA

The use of financial ratios is to give an indication of how healthy a person’s financial health is. Financial ratios are the process of taking financial data from a person’s financial statements to generate key ratios to gauge how he is faring.

There are seven key ratios and they are:

1. Liquidity Ratio: Basic liquidity ratio shows the ability of an individual to convert his/her assets into cash easily. This will invariably show the number of months a family can contribute to meet its expenses with existing cash or cash equivalent assets after a total loss of income.

Liquidity Ratio = cash/cash equivalent (liquid assets)
                                       Monthly Expenses

For a healthy Liquidity Ratio, a general guideline is 3 - 6 months. Anything lesser will mean he/she does not have the required liquidity of 3 - 6 months for emergency. Financial Advice: If an individual does not have 3 - 6 months of liquidity, your advice would be to: 1. Re-budget and cut his expenses. 2. Those extra, put more into his liquid assets. (Banks, Deposits)

2. Liquid Asset to Net Worth Ratio: This ratio will show what amount of a person’s net worth are liquid assets. It also shows the ability of a person to convert assets to cash to meet urgent emergencies such as death.

Liquid Asset to Net Worth = cash/cash equivalent (liquid assets)
                                                                Net Worth

For a good Liquid Asset to Net Worth ratio, the guideline is at least 15%. The more the % the better. Financial Advice: If an individual falls below the 15% ratio, your advice would be: 1. Convert non-liquid assets to liquid. (Easier said than done. Normally an individual who has more non-liquid assets, which would be properties and real estates. In truth they are not easily liquidated. Assets such as Art and Antique collection will also be difficult to liquidate)

3. Savings Ratio: This ratio will show the portion of income set aside as savings for the future. Savings would include investments as well.

Savings Ratio =      Savings
                          Gross Income

A healthy Savings Ratio would have a % of at least 10% or more.   Financial Advice: If a person’s savings ratio falls below 10%, your advice would be: 1. Re-budget and cut wasteful expenses 2. Convert those extra savings into savings plans or investments.

4. Debt to Asset Ratio: It measures the ability of a person to pay his/her debts.

Debt to Asset Ratio = Total Debt
                                  Total Asset
A healthy Debt to Asset Ratio would be about 50% or less. Financial Advice: If a person’s debt to asset ratio is above the 50% guideline, your advice would be: 1. Re-finance the debt if and when possible. 2. Pay up some of the debts if and when possible.

5. (1) Debt Service Ratio: This ratio measures the “Take Home” income, net of CPF contributions (minus employee CPF), used to make regular repayment of debts.

Debt Service Ratio = Total Monthly Loan Repayments
                                             Take Home Income

A good Debt Service Ratio would be 35% below. 45% and above is consider excessive. Financial Advice: If a person’s debt service ratio is above the 35% guideline, your advice would be: 1. Considers re-deeming some of his/her loans 2. Watch this part carefully in the event of loss of income due to retrenchment or disability/critical illness.

5. (2) Non-Mortgage Debt Service Ratio: This ratio compares the annual payments to service all debts except mortgage with a person’s take home pay.

Non-Mortgage Debt Service Ratio =
              Total Annual Non-Mortgage Debt Repayments
                             Annual Take Home Income

A good ratio is 15% or lower. That is because mortgage should take the bulk of the debts. Anything higher would mean over excessive spending in other things. Financial Advice: If a person’s NMDS ratio is above 15%, your advice would be: 1. Cut down on over-spending habit 2. Start on a plan to slowly eliminate each debt one by one.

6. Net Investment Assets to Net Worth Ratio: It compares the value of investment assets to net worth or how much a person has devoted to accumulating capital for retirement. The ratio should increase with age or as a person reaches retirement age.

Net Investment Assets to Net Worth Ratio = Total Invested Assets
                                                                             Net Worth

A good Net Investment Assets to Net Worth Ratio is 50% or more. Financial Advice: If a person’s net investment assets is 50% below, your advice would be: 1. Encourage the person to convert more cash or cash equivalent to be invested. 2. Continue to invest any further available savings.

7. Solvency Ratio: This ratio compares the total liabilities with regards to assets. It shows how much of a person’s assets really belong to him/her. Another area of looking is to observe that when a person’s liabilities exceed his/her assets, his net worth will be negative.

Solvency Ratio = Total Net Worth
                              Total Assets

A good Solvency Ratio is 50% and above. Anything below that would mean a person has borrowed excessively. Financial Advice: If a person’s solvency ratio is 50% and below, your advice would be: 1. To watch carefully, otherwise a person can become technically insolvent. Most of this insolvency can slowly lead to bankruptcy. 2. Start reducing debts.

By: Calvin Yeo, CFP, MBA. Calvin is an independent wealth coach who specialises in coaching people in wealth management and financial planning