Your ‘Back Of A Napkin’ Solvency & Liquidity Check Calculations

So many of us are armed with cool Fitbits and fancy Smartwatches that give us an update on how we are tracking against our daily health goals, but when last did you perform a basic “financial heath check”? The good news is that you don’t need a R5,000 piece of snazzy tech to work out what ‘shape’ your money is in. All you need is a pen, a piece of paper and a calculator. In this blog post we are going to run you through 2 simple financial calculations that can be used to evaluate your current financial situation.

• Solvency Ratio

A solvency ratio is the ratio of your net worth to total assets, expressed as a percentage. Ok, that does sound a little like higher grade Maths, doesn’t it? Why don’t you pick up a pen and paper and open the calculator App on your phone quickly?

Before we move onto the calculation, why is a solvency ratio check so important when it comes to financial planning?

Answer: Because it provides you with an insight into your debt levels. In a nutshell, a solvency check will tell you if your assets are large enough to repay your debts.

Let’s be honest, most of us carry some debt in one way or another, especially if we are in the early stages of our lives and accumulating assets. The trick is to not be in a situation where you are so indebted that you are a pay cheque or two away from bankruptcy.

Here is the low-down:

If you are young, and perhaps newly married, then it’s highly likely that your solvency ratio would be relatively small because you are starting out in life and probably have a lot of debt (like cars, a few personal loans, and perhaps a small mortgage on your first home). However, if you are an older couple, moving into retirement, you would most likely have a higher solvency ratio as you would be trying to eliminate debt completely.

The calculation: Solvency ratio = Net worth / total assets x 100

An example: Refilwe and her husband are a young couple who have two cars and a townhouse. Their net worth is R200,000. They have been able to calculate this by subtracting what they owe from total value of their assets.

Total assets:                       R1,500 000 (two cars and a townhouse)

Total liabilities:                  R1,300 000 (what is still owing on their two cars and townhouse)

Net worth:                          R   200 000

To work out their solvency ratio, we use the following calculation:

R200,000 (net worth) divided by R1,500 000 (total assets) x 100 = 13% (solvency ratio)

You can see that their solvency ratio is low because the couple is still carrying a large portion of personal debt. As they get older, they will ideally like to move that solvency ratio towards 50% and then ultimately up into the 90% as they head into retirement.

• Liquidity Ratio

How liquid are you?

We aren’t talking about your weekend alcoholic beverage intake here 🙂 We are talking about assets that can be turned into cold,hard cash very quickly.

A liquidity ratio is important, to calculate how many months of debt can be funded if your income ceased and you needed to turn some of your assets into cash.

Life can throw us all a few curveballs, and if it does and times get tough, we all need to know how we are going to navigate financially through the tough times.

Making sure you’re “cash flush” and able to meet your debt obligations is important nowadays. Anyone of us could be retrenched, fall ill or be involved in an accident that leaves us unable to generate an income. The problem is that our debt obligations don’t fall away when that happens.

The calculation: Liquidity ratio = liquid assets / monthly debt obligations.

An example: Thabo and Olwethu have R50,000 sitting in a bank account, saved for a rainy day. Other than that, all their other assets are fixed (like cars and a house) and couldn’t easily be converted into cash, in an emergency. Their current monthly debt obligations are R5,000 a month.

To work out their liquidity ratio, they would run the following calculation:

R50,000 (liquid assets) divided by R5,000 (monthly debt obligation) = 10 (the amount of months they could meet their debt obligations).

In this instance, they could cover ten months of debt obligations if their income ceased and they were forced to cash in their R50,000 bank investment.

The higher your financial liquidity ratio number, the better. It represents how many months you can cover your monthly debt obligations.

Rule of thumb. You should probably have enough in the way of liquid assets to cover at least six months’ worth of debt obligations.

If your liquidity ratio is less than 6, it means you have one of two choices, if you land up in a situation where your income is lost:

• Borrow the money from a bank
• Try and flog off assets and personal stuff to make ends meet

Both scenarios aren’t ideal.

It’s best to have some “rainy day” money stashed and to also look at an income protection policy to cover you, if your income loss is a result of illness or injury.

In our next blog post we will look at two more financial planning calculations that you can quickly knock out at the back of a napkin, namely:

• Savings ratio
• Debt servicing ratio

Until next time
The Wise About Life team