You may have heard of financial ratios and there are several commonly used especially when you are talking with your financial planner/adviser or banker. What are financial ratios? Financial ratios are numbers that give you an idea or indication with regards to your financial situation.
They provide guidelines for measuring any changes in your money situation. The relationships give you a snapshot on whether you are making any improvements in your financial position. Below is a list of commonly used financial ratios.
1. Debt ratio
Calculation: Liabilities divided by net worth
Example: $50,000 ÷ $100,000 (Answer: 0.5)
The debt ratio shows the relationship between debt and net worth. A low debt ratio is good.
2. Current ratio
Calculation: Liquid assets divided by current liabilities
Example: $6,000 ÷ $$2,000 (Answer: 3)
The above indicates $3 in liquid assets for every $1 of current liabilities. It is desirable to have a high current ratio and having the cash to pay bills.
3. Liquidity ratio
Calculation: Liquid assets divided by monthly expenses
Example: $20,000 ÷ $8,000 (Answer: 2.5)
A high liquidity ratio is desirable as this indicates the number of months in which living expenses can be paid if an emergency arises.
4. Debt-payment ratio
Calculation: Monthly credit payments divided by take-home pay
Example: $1080 ÷ $4000 (Answer: 0.27)
This ratio indicates how much a person’s income goes towards debt payments (excludes a home loan). Generally, financial advisers suggest a ratio of less than 20 percent.
5. Savings ratio
Calculation: Amount saved each month divided by gross income
Example: $500 ÷ $5000 (Answer: 0.10)
Generally, financial advisers suggest targeting a monthly savings of 5 – 10 percent. Of course, higher is better.
Jacquelyn is the co-author of the books “Teaching Your Kids About Money” and “Top 93 Personal Finance FAQs in Malaysia” with KC Lau. Jacquelyn is the pseudonym used by Amy Sipagal.