Financial Ratios Part I: Liquidity Ratios
Liquidity Ratios can help determine whether or not you have enough current assets to pay for a large, unexpected expense, or enough money too tie you over in case of a period of reduced or eliminated income.
Current Ratio = Current (liquid) Assets / Current Liabilities
The current ratio tells you how many times over you could pay off your current liabilities with the cash you have on hand. The more times you can pay off your current liabilities, the better off you are financially. A ratio greater than 2 is recommended. It is also important to track the trend of this ratio; an upward trend is recommend. If this ratio is going down, you need to make changes to improve your financial situation.
Living Expense Covered Ratio = Current Assets / Monthly Living Expenses
I also like to refer to this ratio as the emergency fund ratio. The living expense covered ratio tells you how long you could survive if you were to loose all of your current sources of income. This is a good measure to see how long you could sustain financially on your current emergency fund assuming the same level of lifestyle. However, this is a conservative estimate considering most people would scale back their standard of living with the loss of income sources.
When calculating your monthly living expenses keep in mind that with the loss of a job you may get rid of certain expense i.e. taxes, charitable giving, savings, etc.
Once again, you should track the trend of this ratio. It should be increasing on a steady basis. Ideally you should have a ratio of between 3 and 6 depending on the volatility of your job.
*For an explanation of the other ratios I use, check out my other financial ratio posts (Liquidity Ratios, Debt Ratios, Saving Ratios, & Networth Ratios).
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[...] Month’s Living Expenses Covered Ratio – We saw a pretty significant drop in our emergency fund coverage ratio from last month to this month. The reason is because we had to take out about $3,000 for home repair projects. We have been planning on doing these projects since we purchased our new home and now that the weather is getting nicer the time finally came to make the withdrawal. We are hoping that by the end of the year we’ll have it back over 12 months. [...]