Quick Financial Ratios

(Part 2 of 4)

In Part 1 of Quick Financial Ratios we covered two ratios that are used to get a more high-level overview of your financial health. In Part 2, you will get an idea of the fluidity of your finances in difficult times. Call it a stress test, if you will.

If you were comprehensive in your detail-gathering in preparation of Part 1, (congratulations!) you would have all the information across each and every asset and each and every liability. Armed with these, you can quickly calculate the remaining financial ratios (thus, Quick Financial Ratios, geddit?).

Liquidity Ratio

Your assets are divided into two categories: Liquid and Non-liquid. The Liquidity Ratio considers your liquid assets as a fraction of your total net worth. It indicates your ability to mitigate unforeseen financial scenarios that urgently require cash-in-hand.

What are Liquid Assets?

Liquid assets are those that are either already in cash or can be converted into cash in 3 – 4 working days. They include cash and cash equivalents (e.g., money stored in most e-Wallets), stocks, mutual funds, fixed deposits, and the like.

They may or may not include your superannuation-equivalents, investment-linked insurance policies, participating whole life insurance policies, and other insurance products because these often take more than a week to be converted to cash (layers of paperwork going on behind the scenes).

What are Non-liquid Assets?

Non-liquid assets include those with a minimum lock-in period that have not been met, real estate, your art collection and that 20-year-old mini-grand piano that sits, quietly disused, in your living room. These take a much longer time to convert to cash, partially because: (i) It takes time to find a prospective buyer (including negotiations on value of asset and terms and conditions of sale); (ii) The transaction is regulated and needs to go through several checks and lodgements, whether mandatory or voluntarily; or (iii) Letting go of these assets prematurely incurs a heavy contractual financial penalty.

Remember the Numbers template I spoke of earlier? It has some examples too:

“But I don’t want to sell my assets at a loss!”

Whether your assets are liquid or illiquid, the value of non-cash assets is almost certainly subject to the forces of supply and demand. You may not want to let it go at the current value, believing you can get more when the market improves. That doesn’t affect the liquid-ness of your assets. The idea of the ratios here is that if it’s gotta go, it’s gotta go, ASAP.

In an emergency, which may stretch for months depending on the type, liquid assets may need to be converted to cash at a loss. When you need it, you really need it. This is why we need to choose our liquid assets carefully and have a strategy for how long to hold on to it. That’s a topic for another time.

The Mixologist says…

Liquidity Ratio = Liquid Assets ÷ Total Net Worth

What this should be depends on the individual and his investment goals. 15 – 20% is a reasonable starting point. Another view is to have enough liquid assets to cover 6 months’ worth of your current monthly expenses to mitigate unforeseen financial scenarios.

“What kind of unforeseen financial scenarios?”

If you and those closest to you don’t have sufficient insurance coverage, medical emergencies or accidents may take a toll on your finances.

You may find yourself unable to work for months due to health issues, family commitments, or retrenchment, and need to dig into your savings to tide things over.

If you have a fur-kid, pet medical emergencies can be very costly. I personally experienced such an emergency in 2016 when I had to send my pet in for a CT scan, due to weak hind legs and suspected growth in its spine, and was set back by more than $3,000. Part of the $3,000 document is shown below. If I had pet insurance (which I didn’t at the time), such expenses might not have been covered, even in part, as it was not followed by any surgery.

These situations do sound like they could be covered by insurance. Paying high premiums to cover low-probability events is a tradeoff decision you need to make on your own, and a topic for another article in this series.

Solvency Ratio

The solvency ratio measures an individual’s ability to meet all his debt obligations, by giving an indication of the amount of assets you have in excess of your liabilities. The lower it is, the more likely you are to default on your debts.

The difference between the Solvency Ratio and the Liquidity Ratio is that the latter is an indicator of shorter-term financial health, whereas the other considers a longer-term time horizon.

The Barista says…

Solvency Ratio = Total Net Worth ÷ Total Assets

It could be restated as follows (I’ll let you doo-de-maff):

Solvency Ratio = 1 – Debt-to-Asset Ratio

Naturally, the maximum possible value is one – if you have no liabilities, then Total Net Worth = Total Assets – and we should aim to approach it as early as possible and by retirement. As with Debt-to-Asset Ratio, an acceptable range for this is subjective; some say keep it above 0.5, others say above 0.67.

Ok wait, if this can be derived from another ratio, why am I repeating it here?

I believe in the importance of ensuring good solvency, which combines living within our means, and investing more in good (and tangible) assets that provide long term benefits rather than short-term gains. I chose to emphasise this by showing two different perspectives on debt reduction. One is by bringing down your debt-to-asset ratio, the other is by increasing your solvency ratio.

At different stages in your life, you might find one of them more depressing (or encouraging) than the other due to the psychology behind the absolute value of the number presented (negative vs positive). For example, in Part 1, I showed my personal debt to asset ratio from my graduation year onwards; this value does not cross zero. Here is the same information presented as the Solvency Ratio. It was nice, psychologically, to know that I actually crossed zero some time in 2009.

Enough about my balance sheet, what about my cash flow?

That is a salient point, especially since this series is called Optimising Your Cash Flow. Thanks for your patience so far. In the next part, we will start looking at ratios that consider your cash flow, i.e., your various sources of income and your expenses. We will begin to explore areas of your cash flow that might need improvement.

Same as before…

Please note that I am not a financial planner and do not represent any financial institution or insurance company. I do not have any qualifications that allow me to sell or market securities or insurance products of any kind. I only have an interest in securities and insurance products and intend to use this platform only to share my personal experience as a consumer of these products. Any views here are my own and should not be considered as expert advice. For proper financial advice, please consult a qualified financial planner.

Finally, clap me if you can!

Click here to go back to the series Optimising Your Cash Flow