In my last post, we looked at our finances through the eye of a company and scrutinized how we landed on our financial statements. You may be wondering what the exercise means and what insight you can get from it to help you get a better financial girth. In this post, I will give you the tools to analyze your financial health and garner insights that you can layer an individualistic financial strategy.
Now there are lots of performance indexes that are thrown around by our CPAs, but all we need are three fundamental KPIs.
The first one is the Profitability Ratio. Financial analysts refer to revenue (aka income) as the top line and net income as the bottom-line. The profitability ratio tells you what percentage of your topline flows to your bottom-line.
How much of your revenue did you retain to increase your equity in your assets? Or was it all just funneled through you.
If you want to attain a consistent profitability ratio, the best strategy is to allocate your retained earnings before any other expense item. Do not save after spending, but spend after saving. Everyone will have a varied profitability strategy, but a good gauge will be a PR ≥ 20%, with 40% as a north star.
You may look at your income and go; Yikes, if I remove 20% from my income, what is left will not cover my expenses. If this is the case, the truth is that you are living above your means, and you can either shrink expenses or increase revenue. Guess which one is faster to do and within your control. It is hard, believe me, I know, but we will not grow substantially if this is not done.
Current Ratio (aka working capital ratio) measures your current assets against your current liabilities. We mentioned in the previous post that current assets are the assets that are cash or can be turned to cash within 12 months, and current liabilities are debts due within 12 months.
Suppose everything on the income statement comes to a grind, are you able to meet your short term obligations. This is the liquidity question
CR ≥ 1 means that you are good, < 1 indicates a need to strategize. Current ratio is even more crucial in these unprecedented times of Covid-19. It helps answer the question; If I lose my job today, will I be ok or will I be in serious trouble? This leads directly to the idea of an emergency fund strategy (we will discuss this in subsequent posts).
The last performance index is Leverage (aka debt to equity ratio). If you have read my previous post, you already know that I obsess about this particular index because I am not a fan of debts.
how financially dependent are you on debts
Banks also use the debt to equity ratio as a valuation metric to determine how much loan can be approved for you as it measures your risk level. The higher your leverage, the riskier your financial portfolio is, which will affect the size of loans, and the interest rates available to you.
My leverage tells me how much of my assets is mine and how much belongs to the bank. The dream is to have assets equal to equity. Even though it is much harder not to have debts when you are younger, having a leverage strategy early on and setting leverage targets for yourself will help.
When people say they have a $10 Million portfolio your natural question should be, what is your equity in the portfolio.
Now, Let us walk through an example
Lydia is a 33-year-old pharmaceutical sales rep and a single mum. She also sells her art on eBay as a side hustle and teaches art once a month. She makes $3000 as a monthly salary, $500 on eBay, $50 for teaching art, and gets $450 in commission and bonuses. Lydia also receives $500 each from her child’s father and the government for child support. Lydia’s total revenue is $5,000. This month Lydia used her net income to buy stocks, increasing her stock value from $5280 to $6250 and her assets from $419,030 to $420,000.
Lydia’s expenses, assets, liability, and equity are in the picture above. Glancing at the financial statement, it seems like Lydia is doing ok. Let us analyze this data and see if she is as financially healthy as she looks.
- Profitability Ratio: Lydia’s profitability is 19.4%.
Strategy: If Lydia reduces miscellaneous spending from $200 to $170, she will hit the 20% PR target and increasing NI to $1,000
2. Current Ratio:
This means that should Lydia lose are job, she will only be able to meet 45% of her obligations within one year, and she will be in trouble if she is unable to secure a job soon. Lydia will have to sell her car or stocks at a loss, or worse, foreclose on her house to stay afloat.
Strategy: Lydia will increase her current ratio from 45% to 100% by increasing current assets. Her $1,000 net income will be allocated to emergency funds, short term stocks, or treasury bills rather than stocks or any other long-term investments. Giving her more stability should she lose her job.
3. Leverage Ratio:
Lydia is very leveraged, but it’s understandable as she is 33 years old and probably a first-time homebuyer. However, she still needs a strategy to reduce leverage as quickly as possible.
“But Yeti, how can Lydia reduce leverage when you just told her to use her net income to increase current assets.”
Retained earnings improve leverage ratio regardless of whether it was allocated towards current or long-term assets. However, if retained earnings is not deliberately put towards debt repayment, debt remains the same.
Strategy: The key here is prioritization and discipline. Increasing current ratio takes priority because its effect is more immediate and devastating.
- Lydia will use net income to increase current assets which will improve CR and leverage till CR equals 1.
- Lydia will change strategy and start converting debt to equity, which will also increase leverage and reduce debt.
- Lydia will only invest or diversify if the interest rate on the investment is higher than the interest rates on her debts. (Be careful when determining the interest rates of investment).
If Lydia wants to take it up a notch she can think of ways to reduce expense or increase revenue and strive towards that 40% profitability ratio north star. This will help hasten the timeline for her financial strategy.
We have concluded the financial health series. In my next post, we will dive into Profitability Strategies which includes revenue strategy, forecasting, expense optimization…etc
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