Personal financial plan – Analyzing your debt
The personal balance sheet and personal income statement provide very valuable information but it is through the use of financial ratios that you can actually interpret the numbers and take corrective actions where necessary. Just as Benjamin Franklin once said “If you fail to plan, you are planning to fail” so let’s move on with our series of articles on how to develop a personal financial plan.
In last week’s article we described how to use liquidity ratios in order to determine if you have enough cash to cover an unexpected expense. In this week’s article we will cover the debt ratio and the long-term debt coverage ratio which will give you an indication if you will be able to meet your debt obligations.
Using the debt ratio
The debt ratio helps you determine how much of what you own is financed through debt. It is calculated by dividing your total liabilities by your total assets. You can find these numbers by referring to your personal balance sheet which is a snapshot of your financial health at a given point in time.
Debt ratio = total liabilities (or total debt) / total assets
For example, if as of January 15th 2015 your total liabilities are $100k and your total assets are $250k, your debt ratio would be 0.40. This means that 40% of what you own is managed by borrowing money. The trend of this ratio should be decreasing as your age increases.
Using the long-term debt coverage ratio
The long-term debt coverage ratio determines the amount of times you can cover your debt payments with your current income. It is calculated by dividing your total living income (take-home pay) by your long-term debt obligations. You can find this information by referring to your personal income statement which helps you track both how much you earn (income) and your spending pattern (expenditures) over a given period of time
Long-term debt coverage ratio: Total living income (take-home pay) / total long-term debt obligations
For example, if for year 2014 you had a total living income of $40k and your total long-term debt was $18k, it would result in a ratio of 2.2. In order to manage your debt “comfortably”, your long-term debt coverage ratio should be above 2.5.
If you would like to know what percentage of your living income goes to pay to your long-term debt, simply take the inverse of the long-term debt coverage ratio, thus total long-term debt / total living income.
$ 18k / $ 40k = 0.45 or 45%
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