Do you keep a check on your financial health?
Financial health check is of paramount importance in every phase of your life cycle. So whether you are a student, a professional, an entrepreneur, a home-maker or even a retired individual, this article is meant for you.
All of us get a health check-up done at regular intervals as we understand that it is extremely important to remain in the pink of health to achieve our dreams in life. However what most of us often forget is that financial health is also as important as our physical well-being. You see, if you don't have the requisite funds then many of your wishes and aspirations in life will remain unfulfilled. For instance, you might have dreamt of buying your dream home, a new car, trips to holiday destinations abroad and so on. A financial health check will help you determine whether your desired ambition is viable at this current point of time depending upon your finances or should you wait to live your dreams. Let us put it this way, undertaking a financial health check at various points in life will help you to side step deep ditches which could lead you to a financial crunch.
Let us take the example of Mr Shah who is 35 years old and has a monthly income of Rs 80,000. He wishes to purchase a new car which is worth Rs 5 lakhs. If the monthly EMI of the car is Rs. 10,000 and the car has a down payment of Rs 40,000 then it is probably within the means of Mr Shah. But before purchasing the car, he not only needs to consider his monthly expenses but also any forthcoming liabilities, which may arise in the near future. If his monthly expenses are high at the present moment, or he would need to fund his children's education in the near future then he can postpone his desire to buy a car till he has enough savings and investments to meet his other priorities.
If Mr Shah would have purchased the car without foreseeing his upcoming liabilities and his current financial status, he would probably be unable to pay for the more urgent needs of his family. Hence you must review your finances before undertaking any major financial decisions in life. This is what a timely financial health check-up can do for you.
The question that might arise next in your mind is how should you keep a check on your financial health?
The first step in doing anything important is to first assess where you stand today and where do you want to reach. When dealing with your personal finances, it is therefore important to start by knowing how financially healthy you are today.
There are a few simple ratios that you must analyse regularly, as this can help you track your personal finances in an effortless manner.
|Debt to Income Ratio =
Total monthly outgoings on liabilities (EMIs)
Total monthly income from fixed sources
This ratio determines the proportion of debt as compared to the income an individual generates. Ideally, your debt to income ratio should not be higher than 30% as you would then be straining your income. You see, this means you should not be spending more than 30% of your income on paying loans / interest on loans. The lower this ratio is, the healthier your finances are. If you have a high debt to income ratio, this could have an adverse impact on your borrowing capacity as well. Most banks would prefer giving loans to borrowers who have a low debt to income ratio, as this would imply that they have a large share of their income freely available and can easily afford to repay the bank's loan. Hence in case your debt to income ratio is too high (say more than 30%) consider repaying a part of your loans especially high interest loans (e.g. Credit card bills etc.) so that you can save a larger portion of your monthly income and remain financially healthy.
Another ratio which you must analyse is the:
| Savings to Income Ratio =
Total monthly savings
Total monthly income
Savings to income ratio determines the proportion of your income that you save per annum. Analysing this ratio from time to time will help you to keep track of your expenses and ensure that you are saving enough to meet your goals. Ideally, you should be saving at least 20% of your monthly income to save and invest. Savings are essential to have enough funds when you really need them. In other words, savings are the means to meet your financial goals and to have a brighter future. You might have some desires such as ensuring that child studies in a business school or having a comfortable retirement. For fulfilling most of our desires and wishes in life we need to have adequate savings.
Savings are also necessary in times of emergencies and contingencies. Here's where the next ratio comes into play.
Contingency Reserve = 6 to 24 months of living expenses
In today's world, nothing is permanent or guaranteed. Hence it is extremely important to create a contingency fund which takes care of atleast 6 to 24 months of your monthly expenses (including any EMI payments you make each month). This can be done by deploying money in a separate bank account or liquid fund. You see, this will protect you in case of any unforeseen contingencies that might weaken you financially (such as loss of job, decline in the monthly income and so on). This is basically to ensure that you live your life comfortably without eroding your savings or until you find another permanent source of income.
You see, savings alone will not be able to fulfil your goals in life. The inflation bug will eat into your life-time efforts if you don't invest your savings appropriately.
| Total investment to income ratio =
Current Value of Total Investments
Total Annual Income
This ratio enables you to determine the proportion of present value of your investments as compared to your current income. A low ratio indicates that you invest only a small percentage of the income that you earn and save. This might not help you to fulfil all your financial goals. Hence it is not only important to save a sizeable amount of your monthly income, but it is also vital that you invest a large proportion of the amount you save.
Analysing these simple ratios from time to time will help you to track your success towards achieving your financial goals systematically.
As we have already established, saving comes before investing. A key to kill most financial problems is to save more and spend less. In all the aforesaid mentioned ratios as well, savings are crucial. There are several ways one can boost his/her savings. You might be surprised at how cutting down day-to-day expenses can lead you to saving a big corpus at the year end. Expenses such as electricity and telephone, credit card bills, frequent dining out etc. can be reduced. You can gain a great deal by alienating luxuries and limiting yourself to necessities and comforts. If you are one of those people whose maximum salary is gone in paying home rentals or debt payments, then you must consider moving to a cheaper home and paying off high interest bearing loans at the earliest. Preparing a budget for all short term and long term outlays will help you to track your expenses and create a consciousness to start saving more. This will not only enhance your savings but in turn will boost your investments as well.
Apart from keeping a track on your expenses PersonalFN also advises you to increase your financial literacy. This will enable you to take better and informed financial decisions. Having better financial awareness will not only lead you to undertake suitable asset allocation but also understand the risks associated with each asset class. It will also help you appreciate the importance of saving systematically to achieve your goals and reviewing your financial plan at regular intervals.
PersonalFN understands that not everyone is well equipped to understand the intricacies involved in the financial markets and might not be able to undertake all their financial decisions independently. Hence while we encourage you to seek the guidance of an expert, it would be prudent to understand and implement these simple rules to keep your finances under control and manageable.
PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.
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