Sometimes people tend to wonder what we can do with the surplus cash that we have at hand. Well, as a start, it is good that there is a surplus in cash, but if we are not careful this surplus may be gone before we even realize and by then it could be too late to think about “what-ifs” and “I-should-haves”.
In financial management, there are parameters that can be used to gauge if one is “financially healthy”. Here are few basic financial ratios one can use to gain better understanding of their state of personal finance:
- Liquidity Ratio: This measures one’s ability to cover unforeseen expenses such as emergencies, car repairs, job loss, etc.
- Debt to Asset Ratio: If there is an solvency issue, you must have assets to cover your debt obligations. If your debt value is too high compared to asset values, then even if you sold off all assets, it may still lead to bankruptcy.
- Liquid Asset to Net Worth Ratio: Consider how much of your assets are liquid or “moveable”?
- Savings Ratio: You should be able to save at least 10% of your income each month to go towards your retirement.
Should a person have a very low liquidity ratio, the first thing he or she needs to do is to start saving money for a rainy day (the amount of which is measured by one’s liquidity ratio). Don’t think about paying off debts (except to service scheduled repayment), and investing at this point should be the last thing on this person’s mind.
Debt to Asset Ratio
If you have a good liquidity ratio (healthy savings) but also have high debt to asset ratio, then you are advised to pare down some of your debts. For instance, a person may have a huge positive net worth, but most of this comes from immovable assets such as real properties. If this is the case, this person should consider increasing the proportion of movable assets by investing in other paper assets such as stocks or fixed incomes to diversify and also to provide some liquidity to the balance sheet.
Savings ratio is quite easy to measure, but if you cannot save any money you bring home, then obviously you have a lifestyle or income problem. You need to tackle that first before thinking about putting your money to work hard for you.
See the Big Picture
What I advocate as a financial planner is that no matter what we decide, we must see the bigger picture, the bigger picture being a person’s life, and what he wants out of it. It is important that our decision correlates and supports our aspirations, and if a decision does not derail our goals and dreams but brings us nearer to them, then this is the right thing to do.
In financial terminology, financial planning is described as a systematic process to organize our finance to help achieve our life goals. That being said, any amount on top of the threshold a person feels comfortable treating as their rainy-day fund should be put to work via investments.
Depending on your marital status, income sensitivity or fragility, health condition, and so on, it is rather advisable to have emergency funds worth at least six months of your take-home income (some will say six months of monthly expenses but I would strongly suggest you look to your take-home income as it is more conservative).
If you would like to strengthen your foundation, you may even create an emergency fund that is worth six months or more of your take-home income plus your loan repayment commitment for an additional 12 months. This will help make sure you avoid defaulting or failing to repay your loan obligations.
Of course, it is rather impossible to save enough to help cover emergencies such as serious diseases and so on. This is why you need to be aware of risks and potential losses and take up insurance. After saving enough to feel comfortable and at peace, you must then invest the surplus and let it work for you. Be a master of your cash; not a servant to it.
About the author
Kevin Neoh is a NextGen Money Coach who works with people to help them transform their relationship with money to improve their lives with the money they have. Kevin can be contacted at firstname.lastname@example.org and www.kevinneoh.my.