This week we started a series on personal financial ratios. Like companies, individuals too need to maintain certain personal finance ratios to ensure financial health. Today, we discuss basic liquidity ratio.
Simply put, this ratio tells you how comfortable your finances are in case you are in an emergency situation. So, in case you lose your job or meet with an accident and are unable to earn an income, this ratio tells you how long you can survive (meet regular expenses) with the same financial standard of living.
Calculating your basic liquidity ratio is no rocket science. All you need to do is divide your liquid assets by your monthly expenses. When calculating your liquid assets ensure to take into account cash, money in savings accounts, fixed deposits and other liquid funds. To know your monthly expenses, you need to include living expenses, lifestyle expenses as well as EMIs of all loans you service, including your insurance premiums.
Example: So if your monthly expense is Rs 75,000 and your liquid assets is Rs 3 lakh, your liquidity ratio is 4. This show that you have fours months' expenses handy. Like wise if your monthly expense is Rs 1 lakh with liquid assets Rs 3 lakh, the ratio would be 3. You have three months' expenses handy.
Are you in the red zone: Ideally if your basic liquidity ratio is in between 3 and 6, you should be fine. But, higher the number, the better it is. But under certain conditions, ensure you have a higher ratio. For instance, you owe a lot of debt; you have irregular income; you have a large family to support; you work in a sector which will bear the brunt of an economic slowdown, domestically or internationally.
Read our earlier article on debt service ratio here.
Keep tracking this space as we discuss next week Leverage Ratio.