Too poor to even pay attention

Question: Please help us. We just woke up one day realizing that we are over our heads in debt. We don’t feel like we are living the life of millionaires. We have an average lifestyle with three children all still in school. Our eldest is in 3rd year high school; our middle child is in 1st year high school; and our youngest is in second grade. We maintain a modest home, two cars (one of which is still being amortized with a bank) to avoid number coding in Metro Manila, and travel for leisure abroad just once a year.—Posted at PFA’s “ask a friend, ask Efren” service at www.personalfinance.ph

Answer: Relax. Take a deep breath. Now smile. Money, and in particular debt can be distracting to the point that you can’t even pay attention.

I really have to know more about your financial situation to give you solid advice. But perhaps I can offer you guides to help you analyze your current situation.

First things first, follow the YAH principle of personal finance. YAH stands for you are here. In other words, construct your financial report card by listing down your assets on the one hand and your debts on the other.  The difference between the two is your net worth. This financial report card is called your statement of assets, liabilities and net worth or SA-L=N.

Start by assigning market values to your assets. Simply put, find out how much cash you could get if you were to pre-terminate (e.g. time deposit), collect (e.g. receivable) or sell (e.g. investment, house and lot, business, jewelries) each of your assets today.

Break up your assets into short-term and long-term. Assets that can be converted to cash within one year are short-term assets. Those that will take longer than one year to convert to cash are long-term ones.

Then further break them up into earning and non-earning. A car that is only for personal use is a non-earning asset. On the other hand, your house may be an earning asset if you are renting out even just one of its rooms.

People are pleasantly surprised to see that they actually have some assets. But having assets is not enough. Assets are basically owned by two groups, your creditors and your own household. So let us see how much other people own of your assets through debts.

List down your debts according to whether they are short- and long-term.  If the debt needs to be repaid fully within one year, that is a short-term debt. Anything else would be long-term. Use the outstanding principal balance to value your debts. In other words, if you were to repay your debts today, how much money would you need to shell out?

By this time, you will have probably guessed that we are trying to determine how much net worth will be left after raising cash from liquidating your assets and paying off your debts. But is a large and positive net worth enough? Not really.

To find out if you are managing your SA-L=N well, we will look at three financial ratios: current, debt to equity and earning assets ratio.

Assume you are not to earn income anymore. Still, debts have to be paid, especially your short-term ones. To find out if you could still properly pay your short-term debts even after your income has stopped, see if your short-term assets are equal in value to your short-term debts. If you divide your short-term assets by your short-term debts, the resulting multiple is your measure of liquidity or current ratio. The answer should ideally be one or higher.

What about your ability to pay your total debts? Well, the ratio to compute is your debt to equity ratio. For a household, the ideal is to have only a maximum of 50 percent of your assets owned by other people or institutions. This means that total debts should be at most equal to your net worth. And with such parity, total debts divided by net worth should equal a maximum multiple of one or lower. This is your measure of solvency.

Lastly, for a household where the breadwinner or breadwinners have yet to retire, the ideal ratio of earning assets to total assets should at least be 50 percent. The ratio will vary depending on age and actual financial circumstances. The younger the household is, the higher the ratio should be. That is why I said earlier that I would need to know more about your actual situation. But a 50 percent earning asset ratio is a good start.

If you want more broad yet still free practical money management tips, please visit www.personalfinance.ph. For detailed, specific and habit-forming personal finance training, you may attend our EnRich™ personal finance and EnRich™ estate planning training runs in Cagayan de Oro, Iloilo, Davao, Cebu, Clark and Manila. Details for EnRich™ training runs may be found in the website.

(Efren Ll. Cruz is a Registered Financial Planner of RFP Philippines, personal finance coach, seasoned investment adviser and bestselling author. Questions about the article may be sent by SMS to 0917-505-0709 or emailed to [email protected]. To learn more about the RFP program, attend a FREE orientation on April 24, 7pm at the PSE Center. E-mail [email protected] or text <name><e-mail><RFP> at 0917-3464126 to register.)