When someone ill is presented to the doctor, a medical exam is usually administered. This will tell the doctor what the actual illness is and the appropriate medication to give. The same is true when it comes to personal finances. But how do you measure your financial well being. Is it your level of income? Is it the car you drive? Is it where you hang out from? Is it where you go on holiday? Is it where you shop from? Is it your bank balance?
In this post I attempt to explain some objective measures of your financial well being. I use a few simple ratios to diagnose your financial situation. The mathematics involved is quite basic. I make one general assumption though. I assume you have a valuable skill or product/service which you are currently exchanging in the market place for some kind of income. It could be employment, business, consulting, etc. Now if you have no income at all it could be because you have not yet found out what the market place needs and you have not yet put yourself in a position to provide that valuable service to a fellow human being. The first step would be to figure out what fellow Ugandans want and then give it to them in exchange for a few shillings. As an example one million new babies are born in Uganda every year. These babies over the next 20 – 30 years will need clothing, education, food, medication, housing, entertainment, transport, shopping, etc. The list is endless! and so are the opportunities!
There are seven basic financial ratios we shall use to measure your financial health:
1. Current ratio. This ratio is derived by dividing your monetary assets by your short term liabilities. This ratio should be greater than 2. The current ratio measures your ability to pay off your short term liabilities comfortably. Monetary assets are things you can quickly convert to cash. They typically include things like cash, fixed deposits, unit trust funds, bank deposits, etc.
2. Living expenses coverage ratio. This ratio is obtained by dividing your monetary assets by your monthly living expenses. This figure should be between 3 – 6 months. This means you can survive for 3 – 6 months on your monetary assets without additional income.
3. Debt ratio. The debt ratio is your total liabilities divided by your total assets. This figure should be as close to zero as much as is possible. The higher your debts the higher this figure and the higher your financial risk and stress levels.
4. Debt service ratio. This figure is your monthly loan payments divided by your net income after taxes. This figure should be less than 40%. If you have very huge loans this ratio will be quite high and you will struggle to go through the month.
5. Net savings ratio. This is your monthly savings divided by your income after taxes. Ideally you want to save at least 20% of your income after taxes.
6. Gross savings ratio. This is your monthly savings divided by your gross income. Ideally you want to save at least 30% of your gross income. Having sufficient savings is like having a water tank at home. When the water goes off you rely on the water tank to sustain you for a few days before water comes back at the main tap. It is inconceivable to have no water tank on your house yet we are comfortable to go about our lives without any sensible savings!
7. Return on investment. This is the profits from your businesses/investments divided by the capital you put in. Try to aim for a minimum of 10% which is what you would typically get from government bonds. You other more risky ventures should give you more than 10% to justify the additional risk.
So there you have it. Attempt to calculate how you are doing financially. If you are doing better than the benchmarks above kudos to you. If your are struggling there is a lot of room for improvement. At least now you have a proper diagnosis and you can begin to address the key issues.
If the issue is too much debt you can begin to adjust your lifestyle and begin reducing your debt. If the issue is low income you can begin to acquire more valuable skills to sell in the market place as mentioned earlier. If the issue low saving you can slowly begin to save. If the return on investment is low you can begin to question the additional time and money you are throwing into that venture.