Eight financial ratios to tell which way the wind is blowing

Amy, with guidance, calculated eight financial ratios to understand her financial situation. The goal ratios indicate how close she is to achieving her goals and being financially independent. The security ratios assess her short, medium, and long-term security, focusing on liquidity, debt, and assets. These ratios help Amy relate her money to her life and consider her emotional relationship with money. The magic of money lies in interpreting the story the figures tell. Hello, Jeremy Deacher and welcome to the Insight Post for Sunday the 21st of April 2024, Eight Financial Ratios to Tell Which Way the Wind is Blowing. So last week I introduced Amy, who grew calmer after the hard but satisfying work of preparing financial statements and discovering her financial situation. But these statements were just a list of items and figures. Amy needed to dig deeper and do some maths to understand the implications and inform fully her decisions about her money and life. So Amy, under my guidance, used the figures to calculate eight critical financial ratios. At the same time, we discussed which way the financial wind was blowing for Amy and what ratios she felt would be acceptable in light of her life's goals. Goal ratios. These ratios tell you how close you are to achieving key goals and reflect the degree to which you are financially independent. One, savings ratio, or the monthly savings divided by the gross monthly income. A high percentage may mean you emphasise long-term security at the expense of living life to the full today. Do you want to live life for today, tomorrow or somewhere routine? Plan to bring this ratio into line with your goals. Two, savings to income, or total savings and investments divided by your annual gross income. You would expect this to grow during your working lifetime, especially if you run a good to high savings ratio. You must, however, ask yourself how much is enough to meet your long-term goals. Three, asset mix, or readily realisable assets divided by illiquid assets. Readily realisable assets can quickly be turned into cash in the bank without significant tax. Illiquid assets include exotic investments and property. This ratio will tell you if you are asset rich and cash poor, which of course can be uncomfortable. Security ratios. These ratios tell you about your short, medium and longer term security. They will flag areas where you might be vulnerable to shocks and changing circumstances. Debt and liquidity feature strongly here. One, liquidity, or cash divided by monthly core expenditure. If you have a security fund that you can draw on within 24 hours, how many months of core expenditure does it cover? Is this sufficient? Two, debt to income, or your total debts divided by your gross annual income. What is the size of your debt relative to your income? This figure should, of course, fall throughout your life. Three, debt to assets, or your total liabilities divided by your total assets. What are your liabilities relative to your total assets? In other words, how much equity is available? Are you comfortable with this, or should you fix another figure to aim for? Four, debt servicing costs, or your gross monthly income divided by your total monthly debt servicing costs. What is the cost of servicing your debt relative to your income? How much of your income is allocated to debt payments, and how much do your debt repayments leave for you to live? Five, debt servicing reserve, or your cash or liquid assets divided by your total monthly debt servicing costs. How many months' debt servicing costs are covered by cash and liquid assets? Is this enough? The magic is in the story. Notice how the key ratios exercise is helping Amy relate her money to her life. The math here is essential, but you will see that we are also asking questions about Amy's relationship with money and the emotions around money, such as, are you happy with this figure? Is this enough, or too much, or too little? It is only a short step to looking at the story the figures tell, and this is where the magic of money happens.