Reality and expectations are often mismatched. Therefore, to avoid this, we must continuously monitor our progress towards achieving our financial and lifestyle goals. It is good to aspire and dream. However, there is a danger of unrealistic expectations that can be attached to our aspirations and dreams. The danger with unrealistic expectations to achieve our aspirations and dreams can be brought about by not being committed to a proper plan of action. Truly, anything is possible if we put our minds to it. As we get closer to achieving our goals, another way to keep motivated is by acknowledging that the progress we have made with our goals is evidence of an ongoing implementation strategy. The change in mindset can maintain the level of importance we place upon our goals and vision board. We have the power to achieve our goals and we also have the power to dictate when we want to achieve these goals.
Our financial planning topic for this week is FINANCIAL STATUS. Personal financial management is a very important component in our financial planning towards achieving our financial and lifestyle goals. It includes practical steps of analysing financial statements, cashflow, assets, liabilities, debt, and emergency fund. The analyses of these different aspects can give us the reality of our financial status.
Financial status
Our financial status can be classified as: living within our means; living from salary to salary; and living beyond our means. Living within our means usually includes having a good savings habit, minimal or no debt, good spending habits, and budgeting. Also, this financial status allows us to understand that there is unrestricted room for growth. This room for growth is what can accelerate our momentum towards achieving our goals. Having a financial status of living from salary to salary, as well as living beyond our means lets us know that some of our habits may be negatively influencing our financial and resource management. These financial statuses usually involve high debt accumulation and unrealistic expectations that are hindering our efforts towards achieving our goals. A way to evaluate our financial health and find out our financial status is by calculating four common financial ratios. Basic financial ratios are savings ratio; debt ratio; liquidity ratio; and solvency ratio.
Savings ratio
The savings ratio expresses our level of savings as a percentage of our total income. Much like store discounts or sales that persuade us to buy, a savings percentage can be a motivating factor towards saving towards achieving our goals. Be mindful to use total income after tax for a more accurate analysis. Also, it is understandable that couples with small children can have a lower savings ratio compared to a couple who are empty nesters.
Savings ratio = Savings x 100
Total Income
Example:
An individual who earns P3 000 per month and saves P300 per month into a savings account. Their savings ratio will be:
Savings ratio = P300 x 100 = 10%
P3 000
Debt ratio
The debt ratio expresses our monthly debt repayments as a percentage of our gross monthly income. This ratio firstly includes an annual calculation to accommodate situations of employment bonuses and other income. Also, this ratio can be an important deciding factor to whether we can afford to take on more debt from a new purchase or to take extreme steps to completely pay off our debt.
Monthly debt service ratio = Annual debt commitment / 12 months x 100
Annual gross income / 12 months
Example:
An individual who earns P3 000 per month and has a car loan repayment commitment of P500 per month. Their debt ratio will be:
Monthly debt service ratio = P6 000 / 12 months x 100
P36 000 / 12 months
= P500 per month x 100 = 16.67%
P3 000 per month
Liquidity ratio
The liquidity ratio expresses a comparison of the amount of liquid assets we have with our current debt as a percentage. Liquid assets include cash and other assets that can be easily converted into cash. This ratio is usually calculated on an annual basis. The higher the liquidity ratio, the more cash that is available or close by to us. Also, this ratio can be an indication of whether we have enough funds that can form part of an emergency fund.
Liquidity ratio = Liquid assets x 100
Current debt
Example:
An individual who has a savings account with P3 600 (from P300 saved per month in the past 12 months) and has a car loan repayment commitment of P500 per month. Their liquidity ratio will be:
Liquidity ratio = P3 600 x 100 = 60%
P6 000
Solvency ratio
The solvency ratio expresses our net worth level compared to the amount of our total assets as a percentage. This ratio can indicate which life stage we are in and can be affected by debt. A high solvency ratio can indicate a newly married couple with few assets and high debt. A lower solvency ratio can indicate an older couple nearing retirement with accumulated assets and no debt commitments.
Our net worth is calculated as [total assets] minus [total liabilities].
Solvency ratio = Net worth x 100
Total assets
Example:
An individual who has a net worth of P10 000 and assets worth P30 000. Their solvency ratio will be:
Solvency ratio = P10 000 x 100 = 33.33%
P30 000
We can now analyse our financial health with these four basic financial ratios. Be aware that some of these ratios can be used to calculate how much debt you can access from regulated financial institutions. Such that the results that arise from some of these calculations, can dictate the amount you qualify for in a personal loan or mortgage loan.
Additionally, we can then compare the reality of our financial status versus our perception of financial status. This understanding can also help us realise if our expectations to reach our goals are realistic. A realistic plan of action to achieve our goals could be the key to our success.