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Financial Adviser: 5 Practical Ratios You Need to Manage Your Money Towards Financial Freedom

You need to monitor key performance indicators to manage your personal finances
By Henry Ong |

 

 

One of the reasons why many people fail to achieve their financial goals in life is due to lack of personal motivation.

 

When you are highly motivated, your mindset changes. You become more disciplined in saving and investing your money. You desire to learn more about investing and growing your savings.

 

Raising your motivation also helps you to become more competitive. By translating your goals into short-term objectives, you can constantly challenge yourself to do everything to succeed.

 

Similar to managing a company, managing your personal finances needs monitoring of key performance indicators to ensure that you are achieving your objectives every step of the way. The indicators are the financial ratios that will help you evaluate your financial health after a period of time.

 

The results of your evaluation can either prompt you to change your plans to improve your numbers or motivate you to achieve more. Here are five metrics you need to know to monitor the progress of your financial situation:

 

 

1.  Know how much you are saving from your monthly income

If you are starting to plan your personal finances, the first thing you need to do is to determine how much you need to save out of your monthly income.

 

Normally, what people would do is to spend the moment they receive their salary before deciding to save whatever that is left at end of the month. As a result, there is not much to save anymore because everything has already been spent.

 

In order to control your spending, you need to take out the savings first before you spend the balance. It may not be easy in the beginning if you reduce your normal spending budget so to manage this, you can start with 10 percent then increase this slowly until you have fully adjusted with your spending habits.

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If you have budgeted your monthly expenses, try to avoid the temptation of raising your spending limit when you make extra income. Whatever income you may get beyond your regular earnings, such as commissions or capital gains from the stock market, must automatically be credited to your savings account. 

 

The higher your savings ratio, the stronger your investment base to build your financial security in the future.

 

 

2. Know how long your savings would last if you stopped earning

How many months can your cash savings last if you decide to stop working now? You can measure this by first adding all your liquid assets, that is, the cash that you keep at home and those that you keep in the bank.

 

As part of your liquid assets, you can also include those receivables from friends and short-term investments that you made in stock market and mutual funds.

 

Once you have summed up all your liquid assets, simply divide this amount by your monthly expenses. The resulting ratio is what you call your financial liquidity ratio.

 

This ratio indicates your ability to stretch your savings in fighting off unexpected financial crisis should you lose your regular income. Ideally, a ratio of six months or more will be good. This will allow you enough time to look for new sources of income should anything happen to you like losing your job, closing a business or getting hospitalized.

 

If your ratio is below six months, this is a sign that you need to work harder by increasing your savings or cutting down your expenses. If, on the other hand, your ratio is way above 12 months, you can limit your ratio back to six months by investing the excess cash to long-term investments.

 

 

3.  Know how much of your monthly income is used for debt payments

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There is nothing wrong with using credit cards for as long as you can control and manage your debt. Ideally, every time you use your credit card to buy something, you must be able to pay the whole amount when it becomes due the following month.

 

But there are instances that you need to pay by installment from credit card. When this happens, you must make sure that monthly debt payments can be financed comfortably by your income. This also goes the same to your monthly amortization from things like car loans or housing loans. The total amortization payments plus your credit card dues must be paid by your monthly cash flows.

 

To compute for your debt servicing ratio, simply add all your short-term liabilities and divide it by your monthly income. The ideal ratio must be 40 percent or less. The lower the ratio, the better because this will mean that the extra portion of your income can be allocated to savings.

 

If your ratio is over 50 percent, you may have to consider lowering your monthly debt service payments by transferring your short-term debt to long-term liabilities or maybe try to restructure with your bank to lower your interest rate and lengthen your payment terms.

 

 

4. Know how much of your monthly living expenses can be paid by income you did not work for

Passive income is regular earnings that are derived from your investments that do not need your active participation. For example, interest income from money markets is income that will be credited to your bank account even if you do not do anything.

 

Other examples are dividends from stock investments or rental income from your apartment or condominium unit. If you have invested in assets that generate passive income, your goal must be to earn enough income to pay off your monthly expenses.

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To measure your passive income ratio, simply add all your income from passive investments and divide the total by your monthly expenses. Your ideal ratio must be 100 percent, which means that all your expenses are financed by your passive income, but if you get only 10 percent, that will be a good start to monitor.

 

 

5. Know how much of your total assets can increase in value over time 

If you are fond of buying designer bags and clothes or the latest electronic gadgets and cars, chances are the value of your net worth will decline in due time because of depreciation, unless these represent only a small part of your total assets.

 

While there is nothing wrong with investing in personal effects for presentation and productivity, a substantial amount of your total assets must be invested in assets that appreciate in value over time. Examples of assets that increase in value over time are stock investments, mutual funds, money markets and real estate properties.

 

Keeping your cash in savings accounts does not count as an investment because the interest that you earn from the bank is negligible at less than one percent per year. You must invest any excess cash into assets that generate income.

 

To determine your ratio, you must take a list of all your assets. This can include your bank account, receivables, investments, house where you are staying and others. Once you are done with the inventory, simply add up all the investments you made that can appreciate in value and divide this amount by the total assets.

 

Ideally, a ratio of 50 percent or more means your assets are efficiently invested. If your ratio is less than 50 percent, you must consciously restructure your total asset portfolio by increasing your capital appreciating assets. Perhaps you can make as policy from now on to invest less on items that depreciate.

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Your goal in achieving a high investment-to-asset ratio is to enable your savings to increase your net worth through capital appreciation of your assets over time. 

 

 

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Henry Ong, RFP, is president of Business Sense Financial Advisors. Email Henry for business advice hong@businesssense.com.ph or follow him on Twitter @henryong888 

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