While maths may not be the most loved subject in schooling years, we still apply certain concepts in our daily lives. Ratio is one such beautiful number which helps us to compare two or more things. Be it measuring in probabilities, in proportions while cooking, betting against odds on a cricket match, doctors using in diagnostic reports, investors using for company analysis, ratios are all pervasive – being used knowingly or unknowingly.
We can use ratios in our personal finance lives too. They can give a quick reality check of our current state of finances. They can also help us prepare in emergency situations. Here a few ratios which can give you a comprehensive view of where you stand financially:
Savings to income ratio: This ratio will give you a fair idea of how much you are saving vis–vis the income earned on a monthly basis. While there is no thumb rule as to what should be the ideal number, the higher the better. However, if the ratio is abysmally lower at under 10 per cent, it should ring a warning bell for you. You may need to have a hard look at your budget and analyse where a significant portion of your income is being spent on. You can even do a quarterly review and compare this ratio across regular intervals to get an idea how you are faring on the savings plan.
Investment to income ratio: You may be earning a bomb and saving like a penny-pincher. But eventually what matters is how much of your savings get translated into investments every month. Because to make your money work hard for you, regular investing is the key to building huge wealth and meeting your future financial goals. It is possible that you may be saving a significant portion of your income but it is laying idle in the savings bank account. This ratio will indicate how much are you investing every month out of your income. The higher the ratio, the better.
Debt/Income ratio: This ratio would indicate the proportion of your income used in servicing EMIs/credit card dues on a monthly basis. The lower the ratio, the better. While there is no thumb rule as such, it is prudent that your debt payments should not exceed 35-40% of your monthly income.
Debt/Insurance ratio: Before paying for household expenses and other financial responsibilities, the first thing that the family of a deceased earning member has to think of is repaying debt. This ratio would indicate the proportion of debt covered by your life insurance. A ratio lower than one would spare your dependants the trouble in repaying any outstanding debt including home loan, o/s credit card dues, personal loan, etc.
Total Savings/Monthly Expenses ratio: This ratio indicates how adequate are your total savings to survive if there is any kind of emergency which affects your income earning ability like job loss, substantial pay cut in job, critical illness, temporary disability, etc. This ratio is measured in months and will show you how financially prepared you are for such events. Total savings here include bank balance, fixed deposits, equity, debt & gold investments, provident fund, insurance policies, etc. If your savings cannot last even for a good 6 months, then it is a cause for concern. Review this ratio before you decide to quit your job & take up a new one or when you start a business as the financial risks are high in such situations.
Investment assets/Networth ratio: This ratio can give you a good insight into how truly rich you are! It would help to evaluate how much income generating assets do you have in your total net worth. Total net worth is the difference between your total assets and total liabilities. You may have a couple of properties and cars but these would all be dead assets. Ideally, you should have more income bearing assets, especially when you are nearing retirement. The higher the ratio, the better.
When you introspect your personal finance data in the form of ratios, they start making a lot of sense compared to standalone numbers. For instance, you might want to put a tight leash on your discretionary spending, maybe reduce your debt or increase your life cover, have more liquid and income generating assets in your total net worth. A word of advice. Involve your family members in this exercise. Your spouse may be aware of certain things better than you do. This exercise would be an eye opener for you about your present financial situation and the weak spots in your financial life which you need to work upon. So, get started and do share your experience with us about the entire exercise.