How do you measure financial wealth?

Is it to look at one’s possessions, like the amount of cash in his bank account, or the cars he drives, the clothes he wears, the house he lives in, or the amount of value he currently has in his stock and real estate portfolios?

If that is so, in other words, does it mean that:

a. A man with RM 1 million is wealthier than one who has RM 500,000?

b. A man with a Mercedes Benz is wealthier than one who drives a Toyota?

c. A man who has a bungalow is wealthier than one who has an apartment?

And the list goes on.

Perhaps, to most people, having possessions is a measure of financial wealth.

For me, I adopt a different idea, where I will measure financial wealth with:

## The Wealth Ratio

So, what is it?

It is a measure of the duration that one could sustain his current lifestyle if he is cut off from his active income today. The formula is as follows:

Wealth Ratio

= Current Assets / (Monthly Expenses – Passive Income)

Note:

To name a few, they include:

Here is an example:

Let’s say, John has RM 50,000 in cash and FDs, RM 50,000 in stocks and another RM 20,000 in unit trust funds. His monthly expenses is RM 10,200 and he earns RM 200 in passive income. As such, John’s wealth ratio is calculated as follows:

John’s Wealth Ratio

= Current Assets / (Monthly Expenses – Passive Income)

= (RM 50,000 + RM 50,000 + RM 20,000) / (RM 10,200 – RM 200)

= RM 120,000 / RM 10,000

= 12 Months (1 Year)

So, John’s wealth can last him for 1 year, if he stops having active income today.

## Who is Wealthier?

So, let’s come back to:

Who of the two is wealthier?

Is it a man with RM 1 million or the other person who has RM 500,000?

What if I tell you that the RM 1 million man spends RM 100,000 a month and at that time, the RM 500,000 man spends RM 10,000 a month?

Well, excluding their passive income, their wealth ratios are as follow:

Wealth Ratio: The RM 1 Million Man

= Current Assets / Monthly Expenses

= RM 1 million / RM 100,000

= 10 months

Wealth Ratio: The RM 500,000 Man

= Current Assets / Monthly Expenses

= RM 500,000 / RM 10,000

= 50 months (4 years and 2 months)

Thus, the RM 500,000 man is wealthier despite having less as he could last a lot longer than the RM 1 million man if both lose their active income today.

## This Concept Applies to Stocks Too …

You might wonder, ‘What is the relevance to what I have just shared above with stock investing?’

Simple. As an investor, I wish to find out a stock’s financial wealth by calculating its current ratio. Current ratio is the wealth ratio of a stock. Its formula is:

Current Ratio

= Current Assets / Current Liabilities

Note:

Current assets are assets that can be converted into cash within 12 months.

Current liabilities are bills that are needed to be paid within 12 months.

Let’s use a real balance sheet (consolidated statement of financial position) as a case study:

What is the stock’s current ratio for 2020?

Here, we find that the stock has reported:

a. Current Assets: RM 3,928.3 million.

b. Current Liabilities: RM 999.1 million.

So, the stock’s current ratio is calculated as follow:

Current Ratio

= Current Assets / Current Liabilities

= RM 3,928.3 million / RM 999.1 million

= 3.93.

This means, the stock has the ability to pay off 3.93 years worth of bills (current liabilities) in 2020. Hence, it is like a man who has RM 393,000 in current assets and he spends RM 100,000 in expenses per annum.

So, does it look like a company that will go bust anytime soon?

Or, is this a company that has the financial means to invest for the future?

Thus, this is why I would do a simple calculation of a stock’s current ratio before investing into it as I would know its financial strength beforehand.

## Homework:

With that, I would like to hand you with two homeworks:

1. Your Wealth Ratio

You may calculate your wealth ratio to know your financial health today. I think it would be helpful to you if you can calculate this ratio on a monthly basis.

2. The Current Ratio of Your Stocks

Check back all the stocks that you are now holding in your portfolio today. Start by downloading their latest financial reports (annual / quarter). Next, you could refer to their consolidated statement of financial position (balance sheet) to get their current assets and current liabilities. Then, calculate their current ratios.

Note:

The above are exercises to help you familiarise with the calculations of both the wealth ratio and the current ratio. It takes more than one ratio to truly make an assessment on a stock deal so please do not make any investment decision only based on a stock’s current ratio.

If you have any questions in regards to the homework given, you may post your questions via email: ian@kclau.com

Ian Tai

Financial Content Machine. Dividend Investor. Produced 500+ Financial Articles featured in KCLau.com in Malaysia and the Fifth Person, Value Invest Asia, and Small Cap Asia in Singapore. Regular Host and Presenter of a Weekly Financial Webinar with KCLau.com. Co-Founded DividendVault.com, an online membership site that empowers retail investors to build a stock portfolio that pays rising dividends year after year in Malaysia and Singapore.