9 Financial Ratios and Rules of Thumb towards Financial Freedom

2019-02-22T18:31:42+08:00By |Investing, Loans & Debt, Personal Finances, Savings, Spending|

What are the 9 Financial Ratios and Rules of Thumb that you need to know and achieve towards financial freedom?

 

We will start of with 4 rules of thumb that help you to know how you are doing in these areas.

Savings & Investment

Savings & Investment = Savings or Investment / Total Income

You need to save/invest at least 20% of your income. If you are an employee whereby your EPF contributions are 23% or more, you should aim to save another 20% of your income to achieve a savings/investment rate of 40% above. The more you save/invest, the faster your journey towards financial freedom.

 

Insurance Costs

Insurance Costs = Insurance Premiums / Total Income

You should be spending 10% or less of your income in paying for your life insurance premiums. If you’re single with no dependents, the spending on insurance should be 5% or lesser. While this is a rule of thumb, 5%-10% should be sufficient for life insurance premiums to adequately cover your risk management needs. Keep your insurance and investments separate.

 

Giving & Education

Giving & Education = Giving or Education Costs / Total Income

Giving such as to parents and charitable causes are good. Likewise, investing in your own growth and education is excellent too. However, it is prudent that giving/education is not in excess until you end up having cashflow problems. A good gauge is that giving/education costs should be 10% or less of your total income.

 

Spending

Spending = Total All Other Expenses / Total Income

Total spending on all expenses should be no more than 60% max of your total income. If you are spending above 60% of your income on expenses, you are likely living in excess. You need to track and look into your expenses in detail to see what unnecessary expenses you can cut. It is not about lowering your quality of life but focusing on cutting spending your money on what does not bring you joy.

 

Next are 5 key financial ratios for personal finances that you need to know where you are at.

Liquidity Ratio

Liquidity Ratio = Cash / Expenses

Your liquidity ratio measures the number of months you are able to meet expenses from cash and cash equivalents (i.e. fixed deposits) + other liquid investments (i.e. shares, unit trusts) should you have no income (e.g. losing your job). It is measured simply by total cash equivalents available divided by your total monthly expenses. You should aim for a cash liquidity ratio of minimum 6 months of expenses. If you include your cash + other liquid investments, you should aim for a liquidity ratio of 12 months above. Maintaining a level of liquidity is important to handle the unexpected.

 

Savings Ratio

Savings Ratio = Savings / Income

Your savings ratio is the % of gross income set aside for future consumption. Excluding your EPF savings, you should be aiming for a savings ratio of at least 20%. Including your EPF savings, you should aim for a savings ratio of 35% above. The more you save, the more you have to invest for your future financial freedom. These savings can be invested in various investment vehicles to create multiple streams of income.

 

Asset Liquidity Ratio

Asset Liquidity Ratio = Cash / Net Worth

An asset liquidity ratio is the % of cash or cash equivalents compared to total net worth. The asset liquidity ratio to aim for would be 20% or above. If you include cash equivalents (i.e. shares, unit trusts, other liquid paper assets), your asset liquidity ratio goal would be 50% above. Your liquid assets can be redeemed very quickly in case of an emergency.

 

Debt to Asset Ratio

Debt to Asset Ratio = Total Debt / Asset

Your debt to asset ratio is the % of liabilities compared to total assets. It can be measured as total debt / total assets. Excluding property mortgages (property loans), your debt to asset ratio should be 20% below. If including your property mortgages, your debt to asset ratio should be 35% below. A debt to asset ratio is important to know how much risk you are taking on. If your debt to asset ratio is high, you are at higher risk of being unable to pay off your debts. Someone may appear to be rich with many assets but may actually be in poor financial health if carrying on too much debt and risks.

 

Debt Service Ratio

Debt Service Ratio = Total Debt / Income

Your debt service ratio is the % of income available to meet debt repayment on all mortgage & consumer loans. It can be measured as total debt / income. Excluding property mortgages (property loans), your debt service ratio should be 20% below. If including your property mortgages, your debt service ratio should be 35% below. The difference between the debt service ratio and debt to asset ratio is that the debt service ratio is measuring how much of your monthly income needs to go towards repaying debt. The debt service ratio is also important when applying for loans as it allows the lender to know whether you are likely able to pay back the loan.

 

What financial ratios or rules of thumb do you need to work on and why?

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