Last article discussed how we can create our financial statements. These statements help us organise our financial data and see our finances on one sheet. However, this information is not in its end helpful but can serve as a source to generate other helpful information e.g. Can we meet our current obligations? Our productivity analysis? Are we growing our net worth?
help us analyse our financial statements, we will be using the tool, “Ratio Analysis”. We will be majorly working with three ratios namely
- Liquidity Ratios
- Debt Ratios
- Performance Ratios
Liquidity Ratios: These explains how easily we can generate cash to meet our expenses/current liabilities
- Emergency Fund Ratio:
Monthly Non-discretionary expenses
Current assets are assets that are easily turned into cash e.g. cash at hand, savings account
Non-discretionary expenses are expenses that we will incur every month, no matter what e.g. food, utilities etc. (These can be gotten from our Statement of Income and Expenditure).
A good benchmark for our emergency fund ratio should be a target of 3 to 6 months. 6 months is more ideal. If it is lower than 3, an individual/family should work on improving it. Also, it is too high say 10, 20, it becomes an issue of over-liquidity. That money can be re-directed to other uses e.g. investment.
- Current Ratio: It shows how many times our current assets can cover our current liabilities.
An ideal benchmark is a target of 1 to 2 times
Current liabilities are short term expenses/liabilities that are due.
This ratio shows whether we have enough money to meet our current obligations and at the same time we’re not having too much liquidity.
Debt Ratio: This compares what we owe to what we own
The target should be less than 0.4 or 40%
Our total liabilities should be less than 40% of what we own. If it is greater than 1, it denotes a negative net worth and vice-versa.
Performance Ratios: These helps us analyse our financial performance
- Savings/Investment Ratio
Annual Gross Income
Target should be more than 10%
These ratios help us clearly see the state of our finances and make amendments where necessary.
Analysis of our financial statements make more sense when they can be compared. Therefore, it is better when we can calculate the same ratios for different periods and determine if we are making progress or otherwise.
We are making progress. Join me next week Monday as we continue this series.
We believe in you!
To your financial independence and freedom.
Analysing Your Financial Statements