Quick Financial Ratios

(Part 1 of 4)

This article is part of the series Optimising Your Cash Flow, where I outline my personal experiences in minimising my expenses and debt and increasing my income and net worth.

Remembering QFR 2012

In 2012, when I was just beginning my journey in personal finance, a friend who is a financial planner introduced me to the concept of using financial ratios, normally used to analyse a business, as metrics to gauge my personal financial health. It culminated in an iPhone app called QFR that we both worked on and published on the App Store.

A user of QFR could keep track of four categories of items: Assets, Liabilities, Income, and Expenses. In doing so, he or she could also monitor certain financial metrics and ratios calculated dynamically by the app; some of those metrics and ratios are described in this series. We tried to gamify it by revealing a picture of a different orchid for every metric or ratio that was in the healthy range and for conscientiously updating details in the app, with the aim being to reveal the entire page of flowers.

Sadly, we didn’t maintain the app and it has since been discontinued, but the lessons I learnt have stayed with me till today.

What do these ratios do for me?

Essentially, these ratios measure the current state of your finances. Knowing where you stand now enables you to set goals on what you want to adjust, and in what time horizon. I’ll elaborate on such goals at each ratio.

Part 1? Of 4? Just how many ratios are there?

I realise that there are many of these personal financial ratios and metrics. I’ll be focusing on the ones that I use regularly and whose components are things you can adjust, namely Assets, Liabilities, Income, and Expenses.

In the spirit of the title, I have split the article into four parts. Parts 1 and 2 deal with ratios that use Asset and Debt. Parts 3 and 4 deal mainly with ratios that use Income and Expenses.

What do I need to get started?

Remember the list of items I asked you to inventory in the Introduction to this series. It will come in handy if you want to calculate your ratios and follow along. If you need a tool to help itemise your assets and liabilities and are on iOS or macOS, I recently discovered that Numbers has an aesthetically-pleasing and easy-to-use template for that (see screen capture below).

Jumping right in…

Total Net Worth

I like to start with this metric because it helps you think about everything you have and everything you owe, information that can be used in other ratios. How you calculate total net worth this may be common sense to you, but humour me and let me go through it anyway.

First, total up your liabilities

Clearly, this includes outstanding balances on loans in your name of any kind, from mortgages to credit facilities to amounts you owe your current (and former… did you borrow too much?) family or friends.

Not so clearly, though, this would include any contractually agreed fees or penalties that you would have to pay when certain events occur, such as early termination of loans, telco subscription plans, or scholarship bond. Note that you need not be the direct beneficiary of the loan, plan, or scholarship for a liability to be present; merely being a guarantor incurs a liability (refer to this MoneySense article to learn about the obligations of a guarantor). The good news is, like outstanding loans, these fees or penalties normally decrease as time flies by in the yellow and green. Stick around and you’ll see what I mean.

Next, total up your assets

Assets here should be physical or financial assets you own that retain value or increases in value over time. Goodwill doesn’t count, even in a good will. Such assets could include the home you live in, other investment properties you own or co-own (your share only, please), stocks, bonds, unit trusts, bank deposits, insurance policies, jewellery and watches. Don’t forget your superannuation or superannuation-equivalent assets; for example, for Singapore Residents, this includes your CPF and SRS balances and investments.

Note that in mentioning insurance policies in the list above, I’m referring to their surrender value and not payouts on occurrence of insured events. The idea here is to determine your net worth right now in the before-crisis and the before-death (I think insurance payouts deserve a metric on their own, but I won’t cover that here).

What I find challenging is assigning a fair value to some of these items because, unlike liabilities, some asset values tend to be subjective. At a car roadshow recently, I asked about the trade-in value of my car. The amounts I was offered ranged from $47,000 to $52,500, by the dealer’s dealers, via Whatsapp, without even looking at the car. Imagine trying to value a Rolex watch, a 3-bedroom apartment, your mint-condition Optimus Prime Transformer from the late 1980s, or that Minotti armchair you’re sitting on.

Total Net Worth = Total Assets – Total Liabilities

I’m guessing you already knew this. The goal, of course, is to increase your net worth. This is a point-in-time metric that changes with every cent you spend or earn, at the whim and fancy of potential buyers and competing sellers, after every Trump tweet, or just by itself over time.

If your net worth is negative, you might be over-stretching yourself financially; aim to make your net worth positive through sustainable means. Or at least aim to make the next ratio less than one.

Debt-to-Asset Ratio

If you have derived your net worth and already have the values of your total liabilities and total assets, this will be quick to calculate.

Debt-to-Asset Ratio = Total Liabilities ÷ Total Assets

I bought my first car in 2005, a red Honda Jazz, just 3 months after joining the workforce, which is also 3 months into serving my scholarship bond. My debt-to-asset ratio after that car purchase was an unhealthy 2.9 (170K of liabilities and 59K of assets including the car), which also meant I had a negative net worth.

It took about 3 years before I brought it down to under 1 (this was during the 2008 financial crisis), as I had by then served more than half my bond and decreased that liability significantly. It would take me another 2 years to bring it down to a healthier 0.31, just before I bought my first home. I’ve maintained it below 0.5 since then, keeping a close watch on this ratio. Here’s a coarse trend chart of my debt-to-asset ratio over the years. Note that buying a car actually reduced my debt-to-asset ratio about 7-fold!

The aim is to keep this ratio low. What that is, exactly, is subjective. Some say it should be below 0.5, while others say it should not exceed 0.33 (which, if you were a company, is one of the criteria to be an acceptable Shariah-compliant investment). I simply say keep it as low as possible, zero if you can (debt free!). Before you start thinking about how to bring this to negative territory, this ratio will not go below zero, because when you lend money, it becomes a positive asset (account receivables) rather than a negative debt.

Decreasing this ratio requires an action plan, adequate discipline to stick to it, and an abundance of patience. If your monthly income remains more than your monthly expenses, then slowly but surely, you will get there. More on that in Parts 3 and 4.

How well can you mitigate financial emergencies?

In Part 2 of Quick Financial Ratios, we look at two ratios that have fluid-related names: Liquidity and Solvency. These give an indication of how well you can mitigate financial emergencies.

As I’ve said 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.