Personal financial plan – Analyzing your liquidity
Have you calculated your personal net worth and spending pattern by developing a personal balance sheet and personal income statement? If you have completed this task, which is the first step of the process to develop a personal financial plan, then you are ready to analyze the data in order to better understand how you are managing your financial resources and take corrective actions where necessary. This is done through simple financial ratios which will allow you to easily interpret the data you have collected.
In this week’s article we will be focusing on liquidity ratios which are important to meet emergencies.
Do I have enough money to cover an emergency?
If your TV goes kaput right before the super bowl, or if your car breaks down just as your vacation is approaching, do you have enough money on hand to get it fixed or buy a new one? To calculate your ability to meet an emergency, you need to compare your most liquid assets (monetary assets) with the amount of short-term debt (current debt). These two figures can be found in your personal balance sheet. By comparing these two values, you calculate the current ratio.
Calculating your current ratio
Current ratio = monetary assets / current debt
If the current ratio is below 1, it is a red flag as it means that you do not have enough cash on hand to cover your short-term obligations. In general, financial advisors recommend to keep a current ratio above 2. It is also important that you take a look at the trend of your current ratio over time. Is it increasing or is it decreasing? If it is decreasing, you should look for the cause. You can keep an eye on your expenses by analyzing the income statement.
The current ratio only considers your short-term liabilities (obligations to be paid within one year) and although you might be paying several other expenses on a monthly basis, they are not taken into account with this ratio. For example, if you are paying a mortgage or an auto loan, these are considered long-term debt.
Using the month’s living expenses covered ratio
To take into account all of your expenses, both short-term and long-term, you can use the month’s living expenses covered ratio. As the name suggests, this is calculated by comparing your monetary assets, with your monthly living expenses.
Month’s living expenses covered ratio = monetary assets / monthly living expenses
This ratio indicates how many months of living expenditures you will be able to cover with your current level of monetary assets. If you were to lose your job (source of income), you would be able to survive for this amount of months. It is usually recommended to maintain this ratio between 3 and 6 which is the average time that it takes to find a new job.
Between the current ratio and the month’s living expenses covered ratio, the latter provides a better indication of your relative amount of cash on hand. As with all ratios, recall to keep track of the trend.