Most people are unaware of certain basic things or factors to look out for, which are basically warnings towards incoming financial peril. If ignored these may prove to be very costly, but if identified at an early stage, they may be corrected to ensure sound financial health and leads the way to efficient and effective financial planning. Let’s see the top 7 signs indicating the need for financial health checkup:
Liquidity check for emergency situations
Imagine a situation where you are suddenly face job cut or meet with an accident which will disrupt your income earning capabilities. Most of the people are experiencing the job loss or pay cut currently owing to COVID-19. You can’t predict such events or developments since they are very much unpredictable. You can check your liquidity position by calculating the liquidity ratio as below.
Cash or most liquid assets (include fixed deposits and equity or ETFs) ÷ Regular household expenses incurred or estimated per month
This ratio will give out the time period for which you have surplus funds on which you can sustain without any income during such period. This is the additional liquid funds which are actually your emergency buffer, which should ideally be not less than 3. If you have liquidity ratio of 1-1.5, then there lies times of trouble ahead.
Also, if you have equity investments done specifically for a goal like children education then do not count that amount in this calculation as you should not ideally consider this for meeting emergencies.
Loans without reciprocal asset creation
Credit card loans or EMIs for luxury (simply put unnecessary items) are just an example of unwarranted loans, which do not lead to any asset creation in the long run. So forget about that high end smartphone which will put a hole in your pocket (almost equaling a month’s grocery) and put your finances to use. You can assess your debt position with following ratio.
Total assets ÷ Total liabilities (loans)
Loans would include long term loans and short term loans like credit card loans etc. Ideally for a person in the age group of 25- 45 years, has higher ratio due to higher long term loans leading to long term asset creation. However, if you are having ratio below 1 or more than 2, then it is time to check and reorganize your borrowers position.
Check the savings ratio
Financial planning starts and ends with savings. Savings should ideally be any amount saved, invested or any surplus earned every month. Any person would be better off with higher savings ratio which can be calculated as below.
Surplus generated or disposable income ÷ Income for every month
If you are encountering ratio below 1, then this is warning sign. It indicates that you are not saving, rather you are spending more. Even ratio more than 2 also indicates that you are borrowing and saving that money (works out only if interest payable is lesser than the interest income on the investment).
Assess where you stand
If you are the person who has already a huge burden of the debt and is responsible for paying up a fixed amount as loan repayment, should assess his liquidity and solvency position. This can be calculated as below.
Monthly predetermined Long term and short term debt repayment commitments ÷ Income earned per month
You need not worry if your ratio is less than 1, rather it indicates effective debt management. However, those of you having ratio of more than 1, have to take a corrective action, as this ratio implies that you have borrowed way over the extent to which you can actually afford to pay off the liability.
Retirement planning
Those of you, who have started retirement planning, may well be ahead of all others, may be able to enjoy the power of compounding. This will not only enhance the retirement corpus for you, but will also ensure that you will achieve it within your time frame, even where your cost of investment is much lower due to early entry as compared to others.
Amount contributed towards retirement planning ÷ Total income earned
Ratio of 5-7% indicates that you are contributing to satisfy threshold for tax saving instruments only, while ratio of more than 10% indicates that you are aiming at building up the retirement corpus for early retirement. However, any ratio below 5% would need reconsideration of financial planning, which would maximize the retirement contribution to optimal levels.
Read here: Impact of COVID-19 on your Retirement Planning
Impulse purchases or exceptional spending behavior
Why is that, every time you go to a mall, you need to buy a dress which will make you regret you afterwards (in terms of cost of course!)? Why is that you can’t resist ordering pizza often which is almost equal to two weeks of grocery payment? These are sheer impulse or unnecessary items, which you buy out of sheer laziness or in the heat of the moment.
Impulse / exceptional purchases ÷ Income earned per month
If you are below 5%, then no reason to worry, because your finances can still handle it (but you will need to prevent such impulse shopping). However, those of you landing in double digit ratio, are in deep trouble. This indicates that impulse purchases have rather become your habit and you are giving in to the temptations, which will land you in a situation, where you won’t have enough to pay for the things you need, because you have already spent on things you don’t need.
What is your worth?
Well not you, but your financial assets and investments! Ideally, positive ratio would bring out the extra-ordinary situation, which proves that your net worth is increasing and you will be achieving your financial goals well before the time frame.
Net worth ÷ Total assets
Where net worth = total assets (includes short term and long term assets) – total liabilities (both short term and long term). So, this net worth may keep on changing every month, depending upon the commitments. However, if you find out that this ratio is consistently negative for more than 1-2 months, then it’s a warning bell which will suggest that, you have borrowed way more than you can afford to pay off later.
Financial planning is a discretionary and yet quite typical procedure, which is ongoing and needs to consider holistic approach. Above seven indicators will give you outline that it is not just about the saving or about investment. However, you need to evaluate, analyze and put up any corrective and preventive measures, for any aspect of the financial planning.
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