“If you can’t measure it, then you can’t change it”- Peter Drucker
All of us would have visited a doctor at some point of time. You would have noticed that besides your name and age, the medical team quickly records a few things like your temperature, pulse rate and blood pressure even before they ask you the reason for your visit. Why?
Because these three or four parameters, commonly referred to as “vital signs” by the medical community, represent the key functions in a human body. By measuring these universally accepted vital signs, a medical professional can quickly get an overall sense of the individual’s health.
Now, let us come to money. Just like your physical health, are there some three or four or five universally accepted vital signs that can assess your financial health? Unfortunately, NO.
On the other hand, management gurus like Peter Drucker and Edward Deming have clearly articulated that what can’t be measured, can’t be improved or managed.
Faced with this dilemma, I have created a framework or simply put, a tool, to help me quickly assess the financial health of an individual in less than 5 minutes. The tool, besides providing a quick and easily quantifiable measure of your financial health, also provides a clear roadmap for strategic and tactical financial planning.
I have named this tool: FITS or Financial vitality score.
FITS: The vital signs
Based on my secondary research, in-depth readings on this subject and most importantly, the myriad interactions with my clients, I have come up with a set of 5 key financial vitality signs:
- Liquidity ratio
- Debt Ratio
- Savings ratio
- Net worth Ratio
- Primary Income Ratio
We will analyse each of them in a little more detail:
Liquidity Ratio
This vital sign helps you to assess the extent of a ‘safety net’ that the individual possesses to withstand an economic emergency.
In today’s uncertain world, where pandemics, economic downturns, medical emergencies and financial catastrophes are a reality; having a large safety net is not only good for your financial health but also for your mental health.
Formula: Liquidity Ratio = Emergency Corpus / Monthly Expenses.
Illustration: Let’s say your monthly expenses are 50,000 and your emergency corpus is 10,00,000 then your liquidity ratio is 10,00,000 / 50,000 = 20.
Debt Ratio
This ratio helps you assess the quantum of debt servicing burden the individual is carrying. A high debt ratio reflects poorly on their financial health.
Formula: Debt ratio = (Sum of all loan EMI / Monthly Gross salary) * 100
Illustration: Say, you have a home loan EMI of Rs 20,000 and a car loan EMI of Rs 10,000. Your gross monthly earnings is Rs 3 lakh. Then, your debt ratio is 30,000 / 3,00,000 or 10 percent.
Savings ratio
This ratio reflects the savings rate of the individual as a percentage of gross income earned. Many times, folks who end up with a bigger retirement corpus are not necessarily higher earners but bigger savers.
Formula: Savings Ratio= [{Gross monthly savings1 / Gross monthly income} * 100]
Savings includes all statutory deductions
Illustration: Assuming you earn a gross salary of Rs 3 lakh with monthly savings of Rs 60,000, then your savings ratio = [(60,000/3,00,000) X 100] = 20 percent.
Net worth (Adequacy) Ratio
This ratio helps one to assess the financial net worth of an individual considering their income and age.
Formula: Net worth (Adequacy) Ratio = [{Actual Net worth / Expected Net worth} * 100]
- Where, actual net worth = Assets – Liabilities
- Expected Net worth = 10% X Age X Gross Annual Income (Pre-tax)
- Assets include the sum of all your assets like home, car, shares, bonds, surrender value of insurance policies, cash and bank balance, fixed deposits, gold etc., while liabilities is the total of all your loans like home loan / car loan / education loan.
Illustration:
If the total assets of an individual are Rs 80 lakh and the sum of his liabilities is Rs 20 lakh, then actual net worth = (Rs 80 lakh less Rs 20 lakh) = Rs 60 lakh. We have assumed here that the individual is 40 years old, with an annual income of Rs 25 lakh.
The expected net worth = 10% X 40 X 25 lakh = Rs 100 lakh.
Net worth (Adequacy) ratio = [[60 lacs / 100 lacs} * 100] = 60 percent.
Primary Income Ratio
Lastly it is very important to have multiple diverse streams of revenue. It is highly risky to depend on a single source of income as any loss of primary income will significantly affect your financial standing.
Multiple sources can include income from property (rentals), income from investments (dividend / interest, capital gains) and income from royalty among others. One should strive to ensure that one's primary source of income (salary or business) does not exceed 80 percent of total income.
Formula: Primary Income Ratio = [{Primary income / Total Income} * 100
Illustration: Let’s say your total income is Rs 30 lakh and the income from your primary source salary is Rs 28 lakh.
Then, your Primary Income Ratio = [{28,00,000 / 30,00,000} X 100] = 93%
How to calculate your FITS Score
This is a two-step process:
Calculate the score for each vital sign
For each vital sign you can get a maximum score of +1 (excellent) and a minimum of -0.5 (poor) with 0.5 for good and 0.8 for very good. The actual value for each factor is compared with a range of values provided to obtain a score for each vital sign.
The FITS score system provides a framework for a quick and easy measurable value for the overall assessment of financial health. Additionally, it helps identify your strong areas (‘liquidity’, where we scored 1) as well as areas that require urgent attention (‘primary revenue ratio’), where we scored -0.5.
Final Thoughts
These five carefully chosen financial vital signs -- liquidity ratio, debt ratio, savings ratio, net worth ratio and primary income ratio – provide you with a quickly and clearly measurable framework to assess your overall financial health.
An action plan to get a score of 1 for each of the key vital financial signs is a good starting point. A focused, dedicated and well-thought-out plan to increase your liquidity corpus, reduce your loans, increase your savings ratio, grow your net worth and diversify your income sources will ultimately only be beneficial to you.
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