After you have created your personal balance sheet and monthly budget, you are ready to use financial ratios as a means of analyzing your financial health. Personal finance ratios convey, in understandable terms, what the raw data itself means. Looking at finances through relevant ratios helps identify economical strengths and weaknesses along with revealing important insights that may otherwise go unnoticed. The most useful ratios, when it comes to personal finance, can be classified into three categories: liquidity, financing decisions, and savings.
What is Liquidity amp; How Do You Test it? To an extent, these ratios can also help you consider ways in which you can cut down expenses and save yourself from making unwanted expenses.
Liquidity is a measure of how able an entity is of paying off current obligations, most often in the short-run. The current ratio measures just this: liquid assets to liquid debt. Liquid assets, or current assets, include all cash and cash equivalents (such as savings and checking accounts). Liquid debts, or current liabilities, include all debts that need to be paid off within the next 12 months. Dividing your current assets by your current liabilities will give you a general idea of how on top of finances you are in the short-run. An optimal current ratio factor would be greater than two, thereby indicating your ability to easily pay off all current liabilities and also handle some unexpected expenses that could possibly come up.
Understanding the Implications of Your Financing Decisions
The current circumstances of your financing decisions become quite clear by looking at the debt ratio, a comparison of total debts to total assets. Dividing everything you owe by everything you own shows your current ability to cover all long-term debts. During certain periods of life this number will be high. If you’re measuring your financial health right after you graduate jobless with several student loans, or right after you purchase a new house on credit, the results of this particular ratio might scare you considering the optimal factor is zero. It can be okay if this factor is temporarily high as long as mitigating total debt is a long-term priority.
Looking at the Savings Ratio amp; Identifying What’s Ideal
The savings ratio helps shed light on what funds are really being allocated to savings on a monthly basis. From month to month this ratio might vary so taking an average of several monthly savings ratios will be a better indicator of your true circumstances. Divide the amount of money you saved last month by the amount of income you earned in that same month. Depending on your present financial situation this might be low, but when possible, the savings ratio factor should be around fifteen to twenty percent.
Ratios certainly don’t tell us everything, but they can be a good reference when looking at overall health of our personal finances. Being liquid, debt-free, and able to save are just a few of the many important features of successful financial circumstances. Working towards optimizing these factors should be a financial priority for all of us.