4 Personal Finance Ratios That Measure Your Debt Risk
What Personal Finance Ratios Should I Be Aware Of?
Nobody intentionally gets into debt, but people end up in a bad financial situation because debt creeps up on you slowly.
When you find that you are unable to pay your bills at the end of the month, you resort to borrowing.
Even though people only plan to borrow in the short term until they can get back on track, they often end up becoming reliant on borrowing and their debt slowly begins to grow.
The way to avoid getting into this cycle of debt is to recognise when you are at risk, and there are a few different measures, which are often used in the business world.
Here are 4 personal finance ratios that measure your debt risk and give you a better idea about your overall financial health.
Debt To Income Ratio
The debt to income ratio is an important measure that tells you how much of your monthly income is currently consumed by debt.
To calculate your debt to income ratio, you need to divide your total amount spent on debt payments by your total monthly income.
When you are calculating this, you need to take all debt payments into account, including credit card payments, car payments, student loans, and your mortgage payment.
If you rent, you should include your monthly rent as an alternative to your mortgage.
When calculating income, include your pay, any child support, pension income, and any side income that you earn.
It’s important that you consider your debt to income ratio because a lot of people underestimate just how bad their finances are.
People tend to assume that they are fine because they can cover debt payments, but if a large portion of your income goes towards debts, it’s easy to slip into a much worse position and become reliant on borrowing if your financial situation changes.
Eventually, you will fall into a cycle of debt and may even have to consider options, like bankruptcy or consumer proposals.
Everybody’s financial situation is different, but as a general rule, your debt to income ratio should be 30% at the most.
Coverage ratio is one of the most important of the 4 personal finance ratios that measure your debt risk.
It measures your ability to pay all of your monthly costs after a loss of income.
A poor coverage ratio means that you will be forced to resort to borrowing immediately if you lose your job or experience a pay cut.
To calculate your coverage ratio, divide your liquid assets by your total monthly expenses.
Liquid assets include any asset that can quickly be transferred into a spendable form.
This includes cash, checking accounts, and tax free savings accounts.
It does not include any long term investments or valuable items that you can sell.
It’s important that you know your coverage ratio because it tells you how long you can survive without an income.
A good coverage ratio means being able to survive for 2 to 6 months before you need to resort to borrowing.
If your coverage ratio is lower than that, your finances are not as stable as you might think.
Your current ratio is similar to your coverage ratio, but instead of calculating how long you can survive before you rely on borrowing, it shows you how long you can continue to pay your debts until you default on the payments.
You calculate it by dividing your liquid and saleable assets by one year’s worth of debt payments.
You can include any assets that you can turn into spendable income in the space of a year, as well as your normal liquid assets
Your current ratio is so important because, once you start defaulting on your payments, the debt collectors will start trying to reclaim the debt.
You may incur late payment fees and your interest rate may also increase, meaning that you get further into debt.
Defaulting on car payments or your mortgage can also mean that those assets are reclaimed.
Demand Debt Ratio
Demand debt is debt that your creditor can request at any time.
An unsecured line of credit, a payday loan, or credit card debt are all demand debts that you may be forced to pay back at any time.
It’s important that you know how much of this debt you can pay back right now if you need to.
You can calculate your demand debt ratio by dividing liquid and saleable assets by your total amount of demand debt.
It’s so important that you know your demand debt ratio because if you have more demand debt than you can afford to repay, you will be in a very difficult financial position if your creditors request repayment.
If you have calculated these 4 personal finance ratios that measure your debt risk and you are concerned about your financial position, we can advise you on different debt relief options, so get in touch today.
You can reach us by phone or fill out an evaluation form and we will get back to you.