Know Your Financial Health

In the previous article, we touched up on the need to evaluate our financial health. To recap, financial health helps us in taking well informed decisions when our financial goals/milestones are met and to define the next set of goals. Reassessing our financial health is a process that repeats. Without understanding our financial health, we cannot manage money.

That said, how do you evaluate your financial health? Try searching for it in google and you would never get a practical answer. They would always refer to financial health as a ratio of income vs expense. Though it is required to to know how much you are saving, that is not the financial health indicator in itself. It is just a by-product of the activity you need to perform.

Financial health is basically a gauge of how safe you are, during when the probabilities turn in favour of a crisis. To understand how safe you are, you need to assess some essential factors. Before we look into these factors, there is no way to quantify each factor using a number and say that beyond this number, your financial health is good. Financial health is an indicator relative to your own lifestyle and it would vary from person to person. Hence it is a matter of self-appraisal.

1. Primary Income Security

Your primary income would be the major contributor to your overall income and due to that reason, it has the highest impact on your financial health. Inevitably, forecasting your primary income security becomes the first step. If your primary income is secure for the next 6 months, you are in a prime position to manage the remaining factors to keep your financial health good. If it is not and you are fearful of being unable to retain the money inflow, your primary focus should be spent on taking efforts to make it secure.

2. Secondary Income Sources

Secondary sources of income would be a smaller contributor to your inflows at the beginning of your career but it should increase as you progress. It is generally independent of your employable age and active working years. Often this is overlooked by most people in a way that they do not build on this source. Most people put in a lot of effort to increase the primary income, but not on the alternative sources. Especially for the salaried people, since your primary income is time bound and you would eventually retire, the alternative sources are what would support your later. Considering that, equal effort needs to be spent on improving the alternative income as you do on the primary one. Not just that, when your primary income is insecure, your backup in alternatives needs to be strong enough to support you through the time you secure your primary income. It is ideal that you should be striving to improve your secondary income substantially over a period of time such that you are no longer dependent on your primary income. You could build on alternative sources by monetising your hobby/interests, rental incomes, part time jobs or even simply by investing.

"Financial freedom is achieved not through your primary income source rather, it is through your secondary income."

This starts out as a supplementary factor to define financial health but ends up as the most defining aspect. So as long as the secondary income appreciates yearly you are doing a good job. On the contrary if it is depreciating, you might want to focus more on improving this income. If the growth in the secondary income is outpacing the primary income you are doing an excellent job!

3. Debt Commitments

This is a no brainer, yet it is the most abused aspect of your financial health. Debt to a certain level can fund your dream, but still it is a direct outcome of mismatch between your “actual” financial capacity and “perceived” financial capacity.

Debt is absolutely avoidable.

Let’s face it, why would you want to enjoy a luxury that you cannot afford with the money you have? Whatever the argument you put forth on the need for you to borrow money, it is irrelevant and not a necessity. Debt due to medical emergencies is the only debt that is justifiable. Yet that can be avoided, if you had taken precautions through means of insurance. Debt not only limits your current financial health, but it also adds a level of uncertainty to your future prospects of financial health. How much ever the first two factors are strong for a person, it gets negated by unsustainable debt commitments. Because, a debt has the capability to throw all your safety out of the window when a crisis hits and your job is at stake.

But unfortunately, in the current world debt traps are laid on every step you take, from education and housing to even taking a holiday. So as a thumb rule, a person’s total debt should not be greater than their 2 years of primary & secondary income put together. And their monthly debt obligation should not be more than 20% of their monthly income(primary & secondary). Beyond this, you are not in a comfortable zone in handling debt and the stress increases as the debt exposure increases, while your financial health decreases.

4. Expenditure

This is another factor that has a negative correlation to financial health. But it is different to Debts. Debts as I said, are not a necessity, but expenditures can be a necessity. Still, unwanted expenditure can be a burden. Every time you get a promotion or a hike, the additional money is used to improve lifestyle. That is a fair reaction, but you should be cautious to know if you are over spending.

“Lifestyle inflation” is a psychological phenomenon where you tend to spend more when you earn more.

It happens when you do not comprehend the need for investing, paying back debts etc.This expenditure becomes a negative correlation to the financial health. Lifestyle inflation can also be caused due to social pressure and needs to be cut down after good deliberation. So, when you see a neighbour, friend or a relative make a purchase and you are tempted to follow the same line, you might want to think if the expenditure would be inline with your financial strength. Rather than thinking to match the purchase, be tempted to match the financial strength required to make that lifestyle enhancing purchase.

Expenditure should be driven only by the first two factors i.e., primary & secondary incomes. In fact, expenditure should not even be driven by your net worth in terms of liabilities such as properties. For example, just because you own a house big enough to park a BMW, that should not tempt you to buy it. Because, your house is not going to fund the purchase, rather, it’s your income that funds it.

Your monthly expenditures including debt payouts is a quick gauge for financial health. If the monthly outflow is < 60% of your total income, your financial health is in a great shape. If it’s between 60% and 80%, you are doing OK, but you should strive to get into the green zone. But if it is > 80% of your total income, you are in significant financial stress and a small imbalance in your income can hurt you big. You have 2 options to improve this ratio. Either cut down on debt and expenditures, especially lifestyle enhancing ones or increase your primary/secondary income. If you choose to increase your income, make sure that you don’t increase your expenditure along with it!

5. Emergency Funds

Emergency funds are your backup built from primary and secondary income. These are liquid cash that is readily available to fund your everyday expenses and other unforeseen critical expenditures that cannot be avoided. It shouldn’t matter if this money generates any return. What matters is, it’s ready availability.

“Emergency funds are like an insurance for your financial health.”

Though a lack of it does not hurt your current monetary situation, it can become a lifesaver at any point in time. You should have funds equivalent to 6 months of your primary income earmarked as emergency funds to sail you through periods of income loss. Any money that you take out of these funds should be replenished as soon as possible.

6. Net-Worth

Assessing net-worth is quite important. It is more related to passive fund management. Your future investments, expenditures, asset allocation and emergency funds depend on what you earn and not on what you already possess as net-worth. Thereby, your financial health forecasting is determined by your income. Your income supports your lifestyle and when you lose that support, you need to fall back on your lifestyle to support your financial health and net-worth,not the other way around. You should not fall back on your net-worth to support your lifestyle until you are retired, because that would be unsustainable. So to consider the financial health as good, the net-worth should appreciate year on year and should not depreciate. But if it depreciates, you need to focus first on stopping net worth depreciation before thinking of cutting expenditure. I explained the reason in my earlier article and to recollect, net-worth decay tends to be of higher quantum than day to day expenses and are rather difficult to spot until too late.

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The article became fairly longer than I expected, but it was necessary to cover the entire topic at a stretch since this could not be logically split into multiple articles. Needless to say, it would definitely help you in assessing your financial health, but as I said earlier, this entire process requires regular self appraisal. This can be a base for the relative study of your financial health from time to time to help you check if you are on the right direction. Finally, please share this with your circle of contacts so that information is shared and not stagnated.

Bonus:

Please take the poll on financial health to understand how you compare with the society at large, so that you can pull up your socks to address gaps.

https://www.getfinsight.com/polls

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