Financial Ratio

Time passes so very quickly. It seems only yesterday that we heard about the death of Michael Jackson and his one year death anniversary just passed on 25 June 2010 . Michael Jackson, one of the greatest pop star in our lifetime, needs no introduction. The legacy of his music will continue in many of us. Some of us will remember him for our childhood songs such as “We are the world” to the more recent “Heal the world”, there are also some who will remember him for his controversial legal suits and lifestyle.

What interest me as a financial planner is how did the proud owner of Neverland who placed his annual income at USD35 million and USD20 million in 1996 and 1977 respectively will have financial difficulties in his final years. That reminds me of what I always tell my clients that it is not about how much you earn but how much you can save. If you are a serious investor, you look at certain financial ratios such as Earnings per share (EPS), P/E ratio etc to determine if a particular stock is worth buying or to assess the financial health of a company. Similarly, we use some ratios in personal financial planning to determine the financial health of an individual and falling out of the recommended range indicates an unhealthy financial situation.

Most of us purchase items using credit cards today. The advantage is you have the privilege to pay by 0% installment for purchases we cannot afford. The disadvantage is because of the privilege we tend to overspend and become a slave to the cards. Very often, one thinks getting additional installment of just $30/mth is no big deal but as the saying goes ‘ Every drop makes an ocean’. You will find the $30 every month plus other little $20, $50 adds up to an amount that may be bigger than your income in no time. Financial planners use the Debt Service Ratio to determine if an individual is taking up too much loans or spending too much. It is defined as the total debt or expenses over the total income.

Debt Service Ratio = Total Debt or Expense/ Total Income

A debt to income ratio of 35% and above signals financial trouble in the near future especially if there is low Saving Ratio.

Saving Ratio = Total Savings /Total Income

As a rule of thumb, it should be at least 10% and the good news is being Asians and kiasu Singaporeans, most of us exceed 20%. Other financial ratio a financial planner use in assessing his client financial situation are:

                          Ratio

Recommended       range                      What it indicates

Basic Liquidity Ratio                                   = cash or near cash/Monthly expenses

 3 to 6 months The emergency fund to pay for your expenses  in the event of loss of income.

Liquid Assets To Net worth Ratio              = Cash or Near Cash/Net worth

At least 15% The ability to convert your assets into cash during an emergency
Investment Assets To Net Worth Ratio =Invested Assets/ Net worth    40-50% It indicates how much you are maximising your cash. Too low may suggest you are overly conservative and having too much holding in cash thus subject to inflation risk.Too high may suggest you are investing too much of your cash and may suffer a bad hit in a market downturn.
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