To accurately assess your financial strength, one must have a basic understanding of accounting financial statements and more importantly, financial ratios. Financial ratios are numerical analysis of simplifying a process of evaluating your financial condition. Let’s take an example of a married couple Aaron & Ashley who currently have two kids Dan & Jessica.
Also, below is the Balance Sheet for the couple Aaron & Ashley who currently have two kids Dan & Jessica
|Jan 1, 2018 – Dec 31, 2018|
|Aaron & Ashley, Checking Acct.||600|
|Total Monetary Assets||4,000|
|Total Tangible Assets||222,000|
|Total Investment Assets||117,000|
|Short Term Liabilities|
|Credit Card Debt||2,000|
|Total Short Term Liabilities||2,200|
|Long Term Liabilities|
|Real Estate Loan||100,000|
|Total Long Term Liabilities||103,000|
|Total Liabilities & Net Worth||339,000|
Below is the Statement of Cash flows for the couple.
|Statement of Cash Flows|
|Jan 1, 2018 – Dec 31, 2018|
|Ashley Salary (Part-Time)||18,000|
|Personal property taxes||1,200|
|Auto Loan Payment||4,000|
|State, City, Federal Taxes||14,000|
|Real Estate Taxes||2,500|
|Total Fixed Expense||$46,400|
|Social Security Taxes||4000|
|Total Variable Expense||$20,500|
Given the above financial statements, lets’s take a moment in assessing the financial strength’s/weaknesses of our couple Aaron & Ashley and get a better understanding of how well they are doing financially.
Can I pay for Emergencies?
The liquidity ratio gives a good indication if you have enough assets to convert into cash in case of an emergency. If in the event of an emergency, your entire income freezes and you are unable to work, the liquidity ratio would help determine the number of months you will be able to meet your expenses. In the case of Aaron & Ashley, we can calculate the liquidity ratio as follows.
Liquidity Ratio = Monetary Assets / Total Monthly Expenses
= 4,000 / (66,900/12)
= 4,000 / 5,575
The liquidity ratio suggests that Aaron & Ashley do not have enough funds to support themselves for even a month is they face an emergency. Ideally, one must have enough monetary assets to save at least three months’ worth of monthly expenses.
Do I have enough Assets as compared with Liabilities?
The assets to debt ratio compare the total assets with total liabilities. It measures solvency and the ability to pay debts. In case of Aaron & Ashley, we can calculate the Asset-to-Debt ratio as follows.
Asset-to-Debt ratio = Total Assets / Total Debt
= 339,000 / 105,200
The ratio mentioned above is a favorable ratio for Aaron & Ashley as they have ample assets compared to their debts because they own items worth three times more than their debt. Now, If hypothetically you owe more than you own then you will be deemed insolvent, if you are in a similar situation and are insolvent, then you should seek credit counseling immediately as you may be at risk of filing bankruptcy.
Can I meet my Total debt obligations?
The total debt service to income ratio gives you an idea of the amount of money spent on gross annual debt with the amount of your gross yearly income. Ideally, Lenders prefer a debt-to-income ratio smaller than 36% (Here’s why?)with no more than 28% of the debt going towards your mortgage. So in case of Aaron & Ashley, the rate is calculated as follows.
Debt service to Income ratio = Annual debt repayments / Gross Income
= (21,600 + 4,000) / 78,500
= 25,600 / 78,500
= 0.32 or 32.61%
Although the ratio of 32.61% is less than 36% it is very close to that mark. The ratio does imply that the couple’s gross income is ideal to make their debt repayment including housing-related costs, but they will have to be careful as they are at the verge of mitigating their flexibility in budgeting other business expenses. The ratio should decrease as time goes.
Can I pay my Debts?
Debt to disposable income ratio divides the monthly personal disposable income into monthly debt repayments. Let’s take a look at Aaron & Ashley debt to disposable income ratio.
Debt to disposable income ratio = Monthly Non-mortgage debt payments / Disposable income
= [4,000/12] / [($78,500 – $14,000 – 4,000 – 1,200) / 12]
= 333.33 / [59,300 / 12]
= 333.33 / 4,941.66
= 0.067 or 6.74 %
Ideally, a debt payments-to-disposable income ratio of 16% or more is considered as being problematic because the person making an increased amount of debt payments and that too at a faster pace would be regarded as questionable financially if there is a loss in income.
As a best practice, it is always ideal to be proactive and manage your finances. One way to accomplish this is by conducting a ratio analysis as presented above. Financial ratios provide you with a review of your present finances. Maintaining an Emergency fund requires for you to have at least 15% to 20% of your assets in a monetary form and to make sure that as you get older the percentage keeps growing.
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