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How good is your financial health?

October 18, 2010 13:31 IST
Identifying the problem is the first step towards solving it. Your financial health, for instance, can be diagnosed by looking at a few ratios. These ratios are easy to calculate and simple to use.

While a good starting point is taking a stock of investments, borrowing and expenses, and calculating the money required to fulfil your goals, these will not give you a full picture of your finances.

Individuals need to look at several financial ratios to identify problem areas, quite similar to equity investors using these to judge a company.

But before doing so, a person needs to know his or her net worth. To get this figure, you need to subtract all liabilities (including loan for house and car) from total assets (including house and jewellry). Net worth shows the financial position of a person.

Keeping track of net worth every year will help you understand the financial progress made each year.

"The amount of risk a person can take depends on the net worth. If a person's net worth is high, he or she does not need to invest in high risk products. Rather, focus on capital preservation," said Sandip Raichura, head – wealth management, PINC Money.

Once you know your net worth, check how you fare on the following ratios:

Liquidity ratio: This indicates your ability to meet financial emergencies. It could be health-related problems of someone in the family or loss of job. To calculate the ratio, you need to consider the cash-in-hand and bank balance, and investments (debt funds and fixed deposits) that can be sold immediately, without incurring a huge penalty or loss.

Financial planners said that equity investments should not be included, as the value can be lower than your investment amount. Divide these liquid assets by net worth and you will get the liquidity ratio.

The ratio should be 15 per cent or more, said financial planners, and this money should be able to take care of at least three-month household expenses and equated monthly instalments.

Debt-to-assets ratio: This will tell you the total debt against assets you hold. To compute this, you need to divide the total debt with net worth. A person should try to keep this much below one. If it exceeds one, you need to see a debt counsellor.

This figure should reduce each year. For people in 30s and 40s, this would be a high figure. In this age group, people borrow to create assets such as home/car. As you close in on retirement, the figure should be zero.

Debt-to-income ratio: This is the most important indicator of your ability to serve debt. This will tell you the proportion of monthly income that goes towards paying off debt (home loan, credit card and so on). The ideal number depends on your age but it should not exceed 0.6.

"Once you are in a comfortable zone, separate your credit card and personal loans from home loans and car loan," said a certified financial planner. The former ones are called toxic, as they are high interest loans a person takes for expenses. They should be paid off as soon as you can.

Savings Ratio: This tells the proportion of monthly savings to the income. More than a financial number to judge the saving rate, the ratio shows a person's attitude towards savings and investments. Divide the monthly savings by the net income and you will get the ratio.

Financial planners say a person should have a minimum ratio of 0.3. A person needs to take the average ratio for the past several months to get a clear picture, as calculating the ratio for just one month would not reveal the correct picture.

Tinesh Bhasin in Mumbai
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