Part of the Financial Planning process involves deriving the personal financial ratios from the Statements of Net Worth and Cashflow. As a guiding principle, the ratios are not meant to be hard and fast rules to be adhered to but rather, serve as guidance towards better financial health.
Basic Liquidity Ratio
This involves dividing the total cash/near cash figure from the statement of net worth, by the monthly outflow figure from the statement of cashflows. This gives a measure of the number of months your current liquidity can provide you in event of job loss. A guide to this ratio is 6 but some advisers use 12 because it may take a year to find another job nowadays. That said, working backwards, 6 months of liquid cash funds to be set aside does make sense for emergency financial purposes.
Liquid Assets to Net Worth Ratio
This involves dividing the total cash/near cash figure from the statement of net worth, by the total net worth figure from the same financial statement. This gives measure of financial liquidity in relation to your financial position. As a guide, it should be around 15%. It is easy to understand the problems associated with insufficient liquidity. However, excessive liquidity may indicate that you are not putting your funds to work harder for you. That said, the excess may be temporary as you might be preparing to make a huge downpayment or something to that effect. Planner should inquire reason for excess.
This involves making the monthly regular liquid savings figure as a fraction of the total monthly inflows figure. Both figures are obtained from the cashflow statement. The ratio should be 10% as a guide. It is a good habit to have, not to spend your entire paycheque.
Debt to Asset Ratio
This involves making the total liabilities figure as a fraction of the total assets figure. Both figures are obtained from the statement of net worth. The ratio should NOT be in excess of 50% to prevent solvency issues. In extreme cases, net worth is negative and technical insolvency means debt principal exceeds available assets with this ratio above 100% levels.
Debt Servicing Ratio
This involves taking the total monthly debt servicing commitments as a fraction of total monthly inflows. Both figures are obtained from the cashflow statement. As a guide, one should not commit in excess of 35% of your monthly paycheque towards servicing debts. Being debt free should be worthy financial goal for all.
Non-mortgage Debt Servicing Ratio
The previous ratio involves total debt servicing, this ratio is an adjustment to the previous ratio with insights of its own. The adjustment is to remove the monthly mortgage debt servicing amount from the numerator. This ratio should not be in excess of 15% of your monthly paycheque. Implicitly, you should not commit more than 20% (35% minus 15%) of your monthly paycheque towards mortgage debt servicing, capping an amount you should borrow in the first place. A non-mortgage debt servicing ratio in excess of 15% may indicate a lifestyle funded by credit.
Net Investment Assets to Net Worth Ratio
This involves taking the total invested assets figure as a fraction of the total net worth figure. Both figures are obtained from the net worth statement. As a guide, it should be in excess of 50% to ensure that you are staying invested for the long haul because certain financial objectives like retirement, are ongoing.
Clearly before the ratios can be derived, the financial statements need to be prepared first. Preparing the financial statements takes effort and there are tools out there to help you do so. However, gathering the necessary information beforehand takes effort too. Such an exercise should be done at least once a year as a review. Your financial health is important, right?