When it comes to finances, most people are used to thinking that as long as you can purchase items you need, your finances are in good shape. But that is only a tiny portion that can indicate the status of your finances. In this article, you’ll learn about the indicators that will help you determine whether you are doing well financially or not.
The amount in your emergency fundPhoto by: Hans Splinter
The amount of money you have saved as an emergency fund will dictate how much you can afford to pay for an emergency expense without going into unnecessary debt. Because debt affects your financial health, it’s important to have a sufficient emergency fund to deal with the unexpected.
A good emergency fund should help you survive for at least six months without earning anything. This means it should cover all your basic expenses like housing, food, and other utilities. Besides an emergency fund, it’s important to have some extra cash in savings that will help you deal with smaller expenses that can sneak on you. If you have made progress towards this goal, then your financial health is improving.
Your total net worth encompasses all the money you have at the moment and the total value of all your assets in contrast to the debts you have. Ideally, your net worth should rise gradually as you progress through the years because you have ample time to put away money for your retirement.
This tendency has resulted in financial goals that have been classified according to your age. For instance, experts suggest that your retirement savings are supposed to be around half of what you earn in a year as you approach thirty years. On the other hand, your net worth is supposed to be two times your annual income by the time you get the age of 40. Among all other indicators, it’s your net worth that can guarantee your long-term financial health.
While declining net worth and an increase in debt are seen as unattractive, it is not always the case. If you can understand what has caused the reduction, you can know what is happening and how to tackle the situation.
However, it’s always good to understand whether your assets declined as a result of overspending or they are responding to market changes. At the same time, an increase in debts is sometimes alright if used responsibly. For instance, if you’ve taken a loan to advance your education or fund your startup, then that is considered a good debt since it will pay back many times over.
Your financial ratios
There are several ratios that are important when considering your financial health. These numbers revolve around income, debt, and savings. They give you a better understanding about the progress of your financial profile so that you can make adjustments where necessary.
The right target depends on your age but younger people shouldn’t use more than 30% of their total income to service their debts. In addition, the percentage used to pay debts should decline as you get older and stand at zero before you retire.
1. Savings ratio
When it comes it savings it’s important to look at the savings ratio, you should put away at least 15% of what you earn but you can increase this figure to 25% if you are planning to retire soon. But this is something that will depend on several factors such dealing with college fees for your children.
2. Liquidity ratio
The liquidity ratio determines how long you can survive if all your sources of income were to stop abruptly. The liquid cash represents all your liquid assets like cash in hand, bank savings, liquid mutual funds and fixed deposits.
As a rule of thumb, a constant liquidity ratio is important in preventing financial difficulties in future. While the liquidity ratio will vary with different age brackets, you should aim to have at least five times your gross monthly income lying somewhere.
3. Debt asset ratio
The debt to asset ratio will help you determine whether you have borrowed more than you should. This number is important when you are considering taking a loan. If you have gone beyond your limits, it means that adding another loan will raise your liabilities significantly.
4. Debt servicing ratio
A debt servicing ratio shows your current debt obligation in contrast with your gross monthly income. Ideally, it’s good to keep your debt servicing ratio below 40% at all times. Unfortunately, most people are now acquiring most of their purchases on credit and it has led to an ever increasing debt servicing ratio.
The indicators discussed above are among other different indicators that you need to be conscious about. However, knowing is just the starting point and you should now embark on growing your savings as well as a contingency fund. If you can focus on lowering your debt to income ratio, it’s likely that your financial health will significantly improve over a few years.