Ratio Analysis in Personal Finance
Ratio analysis is considered to be very important when it comes to making financial investments. There are many retail investors who know the value of retail investments. As a result, they also routinely perform a ratio analysis for companies that they invest in. However, surprisingly, a lot of these analysts do not perform a ratio analysis on their own personal finances. This is because there is a prevailing belief that ratio analysis should only be done for big companies. However, this is far from the truth. The reality is that ratio analysis is as relevant in personal finances as it is to institutional financing. However, the ratios used in personal finances are slightly different as compared to those used in corporate finance.
The list of ratios relevant to personal finance as well as their explanation has been provided in detail in this article.
Solvency ratios are used in personal finance as they are used in corporate finance. The idea behind the solvency ratio is the person should have enough cash on hand to ensure that they are capable of meeting their short term expenses. When it comes to companies, they have access to cost-effective sources of short-term financing. This is the reason why a solvency ratio of 1 is recommended in most cases. However, this is not the case when it comes to individuals.
Individuals do not have access to cost-effective sources of short-term funding. Hence, if they fall short of cash in a given month, they are more likely to resort to using credit cards or payday loans to fill the gap. These financial instruments charge very high-interest rates and hence must be avoided. This is the reason that individuals are expected to have at least 3 to 6 months of their monthly expenses in short-term liquid assets. This is the first step in a lot of personal finance techniques and is often referred to as the emergency fund.
The savings ratio is quite simple to calculate. The savings ratio refers to the percentage of personal income that is being plowed back in savings. The specific definition of savings rate may vary since in some approaches involuntary contributions to government-mandated savings programs are counted whereas in other approaches it is not counted.
The savings ratio has been the single biggest factor in personal financial success. When it comes to personal finances, the discipline showed in making financial investments at a consistent pace tends to outperform asset allocation skills.
This means that studies have been conducted, which show that investors with lower incomes have beaten investors with considerably larger incomes as compared to them. This has been made possible since they regularly save a larger chunk of their money and invest it. For instance, a person earning $70,000 but saving 50% of it will have a higher net worth than a person who makes $100,000 but saves only 25% of their income.
The savings rate depends upon the personal philosophy of the investor. However, it is recommended that at least 15% of the post-tax income be saved. Failure to do so would mean that the investor would have to live paycheck to paycheck with no resources to fall back upon.
Debt Coverage Ratio
In a way, the debt coverage ratio is the opposite of the savings ratio. The savings ratio measures the percentage of income being saved, whereas the debt coverage ratio measures the percentage of income that is being committed to fixed expenses every month. Mortgage payments, car payments, education loan payments are all part of the debt coverage ratio.
Ideally, the debt coverage ratio of an individual should not exceed 40% of their post-tax income. This means that as soon as they receive their salary, they should not pay more than 40% of it out immediately. However, the reality is that for most people staying in urban areas, they pay anywhere between 60% to 75% of their income out on the first day itself. These are dangerous levels of leverage, particularly because if the interest rates rise, it could lead to a rise in monthly payments, which would make the financial situation untenable.
Personal Cost of Debt
Just like companies calculate their cost of capital, individuals too can calculate their personal cost of debt. Just like companies, the debt can be a weighted average of all the debts that a person is carrying. Having a target for the personal cost of debt is important since it keeps the person away from high-interest debt such as credit card debt. There are several low-cost debts, such as mortgage debt and even education loans. The personal cost of debt segregates between high-interest debt and low-interest debt. When an investor tries to maintain this level, they consciously try to avoid high-interest debt.
Target Net worth Ratio
Goal setting is a very important part of personal finance. In the absence of proper goal setting, the personal finance exercise would simply be futile. A lot of people following personal financial plans struggle with setting the correct goals regarding their net worth. This is because they do not have a benchmark to compare it to. They do not know what is an expected net worth given their age. For this purpose, a number of personal finance experts have created different target net worth formulas. These formulas take in a couple of factors, such as the age of the respondent as well as their annual income. The formula then provides the expected net worth as an output.
For instance, the popular book The Millionaire Next Door has a formula for calculating the target net worth. The formula is as follows:
Targeted Net Worth = Age * (Annual Pre Tax Income/10)
For instance, if the annual pre-tax income of a person is $100,000 and their age is 34, then their target net worth should be 34 multiplied by ($100,000/10), which equals to $340,000. The investor can then compare their actual net worth to this number to verify whether they have met their goals. If they havent met their goals, then they will know exactly how far they are lagging behind, which will help them catch up with their peers.
Passive Income Ratio
Personal finance experts advocate that as the age of a person increases, the ratio of their passive income in their total income should also increase. This is symbolic of a more balanced approach to finances. In the absence of passive income, a person is just exchanging their time for money. There is a limit to the amount of time that can be exchanged for money. This is the reason why passive income needs to be generated.
It is important to track this number since it helps us understand how close we are to financial independence. A person who is earning 25% of their income from passive sources is better off than a person who is earning 100% of their income in the form of salary. This is because passive income does not take time and effort from the investor. Also, the tax treatment is favorable for passive income.
Insurance is the backbone of a personal financial system. Most personal finance advocates will recommend taking insurance as soon as you start a family. This is because life is uncertain, and hence every investor must have a system in place to provide for their loved ones in case they pass away. There is a ratio to measure the amount of money that would be sufficient in order to provide for the need of the dependents. This ratio is considered to be anywhere between 15 to 25 times the gross income of the person.
Similarly, it is also important to ensure that a health insurance plan has been taken. It is not correct to depend on the life insurance provided by the employer. This is because it is possible that a person may be laid off. If such an event were to take place, it would leave the person without insurance as well as without an income! It is recommended that a person should have a health cover of at least 75% to 100% of their annual income.
Insurance is easily the most ignored part of financial planning. This is because a lot of people consider insurance to be an expense. However, medical debt and the loss of the main breadwinner are the leading causes of bankruptcy in most parts of the world.
Asset Allocation Percentage
There is a general consensus amongst personal finance gurus that young people should allocate more of their money towards risky assets such as equity, whereas old people should allocate less towards equity. The problem is that old, young, less, and more are all subjective terms, and a system is needed to express them in clear and unambiguous terms.
A formula has been developed for this purpose as well. The formula is as follows (110 age) is the percentage that should be invested in equity. For instance, if the age of a person is 35, then they should invest 110 35 = 75% of their investments in equity. In this case, as the age increases, the amount of money to be allocated to equity needs to be decreased automatically.
Debt Coverage Ratio includes mortgage expenses. However, many financial experts calculate mortgage ratios separately as well. This is because a lot of investors tend to think of a mortgage as an investment. However, the fact is that it may not actually be an investment. If the prices of the mortgage stabilize and even fall in the future, then the finances of the investor might be severely hit. This is because a mortgage is a highly leveraged investment. Most personal finance experts will agree that the mortgage payment should never exceed 25% of the net take-home pay of the family, or else it can cause unnecessary duress.
The bottom line is that just like companies, personal finances can also be understood relatively well using ratios. Using these ratios as guidelines, investors can structure a financially stable life for themselves. These ratios can be used as milestones that need to be achieved.
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- Process of Financial Planning
- The Financial Life Cycle
- Three Types of Income
- Misconceptions about Personal Finance
- Macro-Economic Factors and their Effect on Personal Finance
- Going From Financial Goals to a Financial Plan
- Components of a Financial Plan
- Personal Financial Statements
- Advantages and Limitations of a Budget
- Ratio Analysis in Personal Finance
- Dollar-Cost Averaging
- Pitfalls of Dollar-Cost Averaging
- Value Averaging Method of Investment
- The Rent vs. Buy Decision
- Financing Your Home
- Fixed-Rate Mortgage vs. Adjustable Rate Mortgage
- The Phenomenon of House Poverty
- 5 Step Retirement Planning
- Retirement Basics: 401K Plan
- Retirement Basics: Roth IRA
- Auto Loans and Personal Finance
- Earnings Power in Personal Finance
- Personal Financial Planning For Small Businesses
- Common Pitfalls of Tax Planning
- Zero Based Budgeting System Using Envelopes
- The Concept of Financial Freedom
- The Financial Independence Retire Early (FIRE) Movement
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- Rich Dad Poor Dad Philosophy
- The Pay Yourself First Principle
- Personal Finance Lessons from Rich Dad Poor Dad
- Estate Planning in Personal Finance
- 7 Personal Finance Mistakes to Avoid