An investor is known by the ratios he keeps. A number of metrics define his portfolio, revealing its true nature in terms of solvency, liquidity and his ultimate bete noire — costs. Ratios help him assess the state of his personal finances in a scientific manner. Some indicate whether he is prepared for emergencies, while others evaluate his ability to borrow more or whether he should recast his asset allocation in keeping with changing conditions.

The smart individual views his financial health through the prism of ratios, and not merely on the basis of macro but stand-alone factors such as earnings and expenses. Ratios are derived from a series of variables, which, when stacked up methodically, provide a fairly clear idea of the investor’s risk-taking ability.

It is possible to line up several kinds of financial ratios. An investor can use the lot to conduct a precise analysis of his portfolio. Realistic conclusions can then be drawn and corrective actions taken. However, for the sake of brevity and convenience, let us identify three of the most relevant ones today. We will start with the most preliminary of them — Liquidity Ratio (LR).

Liquidity Ratio

In its simplest form, LR may be ascertained thus: Cash divided by monthly expenses.

The answer will tell you whether you are sufficiently sorted in terms of your access to cash. Now, we all understand that holding cash (which gives no return) is a terrible idea in this day and age. Ergo, it is practical to expand its scope to “near-cash” or “semi-liquid” assets. The latter will cover money lying in savings and current accounts in banks. Liquid or money market funds may be included as well. The divisor (that is, monthly spends) should encompass total expenses, including incidentals.

Let’s say an investor spends a couple of lakhs every month (on both discretionary and non-discretionary items), and has Rs 5 lakh in bank accounts and Rs 10 lakh in money market funds. His LR will then stand at 7.5 (15 divided by 2). That is, by and large, a fairly decent score, and the individual concerned need not start worrying about an immediate shortage of liquidity. A lower LR, say, 1 or less, will mean he can barely sustain for a month. In short, that is quite a frightening scenario. Conventional wisdom suggests that an average investor should be capable of covering at least six months or no fewer than two quarters. There is no hard and fast rule, of course, but theories such as these are often considered normal.

Savings Ratio

Savings ratio (SR) comes to the rescue at this stage. It denotes how expediently you squirrel away or how thrifty you really are. A moderate rate — 15 per cent seems alright to some, but this can vary considerably — is warranted. SR may be determined by dividing your total savings by your aggregate earnings.

Savings and earnings recorded round the year are two inalienable components of the investor’s overall profile. How much should one save every year? This happens to be a most fundamental query, all classes of investors have tried to answer it through the ages. A monthly SR may also be found out if necessary, but that usually calls for an elaborate analysis.

To cut a long story short, your SR will reveal how much of your income (before tax) you are eventually putting aside for new investments in an organised manner.

It is often argued that a middle-income investor will outdo his well-heeled counterpart if the former’s SR is consistently better, assuming other conditions do not restrain him. Simple everyday logic suggests that we should save as much as we can; SR enunciates the principle well enough.

Debt Coverage Ratio

Debt coverage ratio gauges the share of earnings that is spent on meeting debt obligations. A typical, contemporary individual frequently has sundry loans to provide for. Home loans are increasingly getting popular, so are auto and education loans. An ordinary household allocates a pretty penny every month for servicing such commitments these days.

For correct assessment of debt coverage, all loans should be factored in. Credit card loans, which can drain budgets, should not be forgotten.

So DCR is total debt obligations divided by total earnings

What ranks as the ideal DCR? Some opine vehemently that 25 per cent should be the absolute upper limit; any figure beyond this will spell disaster. Once again, there is no rule of thumb. But ordinarily, not to make too fine a point on it, I believe 20 per cent can be accommodated. This means up to a fifth of one’s earnings may be earmarked for debt. Once again, I will take into account only the post-tax figure.

I must, at this stage, strongly advise each individual to consider his personal parameters and arrive at correct decisions. Such an exercise will enable him to answer the following questions:

1. Is the investor saving enough in relation to his income? If not, is there room for improvement?

2. Is he ready to tackle a sudden increase in normal expenses or even contingencies, financially speaking?

3. Is the investor too leveraged? Should there be a conscious effort to lighten the load?

The last word

It is important for an investor to assess whether his money will last beyond a certain point, that is, beyond a specific level of expenditure. The issue here is linked essentially to longevity.

Far too many people around the world have outlived their savings. For how many years can the individual sustain himself if he is unable to increase the size of his allocation? And what happens if his kitty turns ‘static’ all of a sudden?

Determining the key ratios will give you a fine insight into your pecuniary affairs. You will know that your liquidity status should ideally remain stable irrespective of circumstances. That will, in the very least, keep you on your toes. You will also remain alert on the savings front, which is almost universally marked as the biggest factor responsible for one’s financial well-being. Unmanageable debt coverage too will impart a few raw lessons, especially if interest rates keep advancing.

I do understand that knowledge of ratios is largely limited to textbooks. But ratios help us to remain disciplined and focused. As for the gainers, their portfolios are often seen as exceptional. The diligent practitioner who gets his math right definitely becomes a trend-setter. As I said at the outset, an investor is known by the ratios he keeps.

The writer is director, Wishlist Capital Advisors