Take Stock

The first step to planning out personal finances is to take stock of your current position. It is extremely important for an individual to understand the deficiencies of his or her portfolio and remedy the situation before it gets beyond a corrective measure. In this article, we look at understanding the present to ensure that the future is smooth sailing.

Family Income – expenditure statement

The first step towards understanding a family’s financial position would be to prepare the income – expenditure statement. To prepare this statement you need to list down all cash outflows (expenditure) and cash inflows (income) under every head such as salary income, rental income, investment income, Equated Monthly Installments (EMIs), children’s education expenses etc.

Let us take the example of Mr. Prakash, who is 28 yrs old and earns an income of  Rs.80, 000 p.m.

By listing down his income and expenses, the following aspects come to light:

  • His housing loan EMI forms a major proportion of his total cash outflows. If he has sufficient liquid funds, he can consider part payment of his housing loan to reduce his EMI.
  • This analysis shows that he has a surplus of Rs.17, 000 which can be used for investments.

Net-worth Statement

A net-worth statement is a way to measure your overall financial position. It is a comparative statement that lists down the assets (what an individual owns) and the liabilities (what an individual owes). Similar to a company’s balance sheet it gives us an insight into financial health. Taking further the example of Mr. Prakash, his net-worth statement is as follows:

The above table shows the net-worth of Mr. Prakash at Rs.2.8 lakh. A major portion of his assets are covered by liabilities which is definitely not a good sign. However, he has age on side and it is not unusual to find young individuals to have low or even negative net-worth. As you inch closer to retirement, it is essential to have as low liabilities as possible, in other words a high net-worth.

Existing insurance covers

The next step would be to list down all the existing insurance policies serviced by you:

  • Life Insurance – mention sum insured amount, number of policies and total premium paid. Include personal accident cover, if any
  • Health Insurance – include health cover provided by employer and policies held on individual capacity
  • Other Insurance – include other insurance policies if any; for example – taken on assets such as jewellery, house etc.

Specific investments

In the previous issue, we had covered the various goals which you may have. And accordingly, specific investments might be earmarked for few or all of the goals. It is useful to separately list down such investments explicitly mentioning its purpose.

Four Vital Ratios – simple yet effective

Liquidity Ratio

What it is: This ratio tells you whether you will be able to meet emergency needs with ease. It gives the number of months you will be able to meet your regular expenses in case your income stops suddenly due to, say, a job loss or a medical condition.

How to calculate it: Divide your liquid assets by your monthly expenses.How much is enough: As a general thumb rule, a ratio of 3-6 is good, but this ratio changes with your age, income and financial situation. If your liquidity ratio is say 8, then it means that you will have enough liquid assets to meet your current monthly expenses for the next eight months. A person with a ratio less than two is definitely in the danger zone and it is advisable for him/her to start investing some additional cash either in a bank account or a liquid mutual fund.

Savings Ratio

What it is: This ratio tells you whether you are saving enough for your future. It is basically the proportion of income you set aside as savings and is expressed in percentage terms.

How to calculate it: To reach this number, divide your savings per month by your net income per month.

How much is enough: Generally, an individual should have a savings ratio of at least 10 per cent, but your savings ratio should be as high as possible. If your savings ratio drops below 5 per cent, your financial future could get in some serious jeopardy. It would be wise to start investing a higher portion of your salary so as to improve your savings ratio.

Debt-Service Ratio

What it is: This ratio is the portion of your income that goes to repay your debts and shows how far you are from a debt trap.

How to calculate it: Divide your total EMIs on all your loans and debts by your total monthly income to get this ratio. It is expressed in percentage terms.

How much is enough: Conservatively, 35 per cent is considered to be an ideal ratio. However, in today’s world it is difficult to sustain without taking loans. Thus, 40-45 per cent is considered to be ideal and anything more than that means you are close to a debt trap.

Leverage Ratio

What it is: This gives you the level of debt you are into in relation with your assets.

How to calculate it: Divide your total liabilities by the total assets you may have. It is expressed in percentage terms.

How much is enough: Your leverage ratio should never be more than 50 per cent. Say if your leverage ratio is 70 per cent, it tells you that 70 per cent of your assets are currently financed by debt. A high ratio is dangerous since any increase in interest rates may get you in a tight spot.