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Prevent Overstretching By Debts!
Posted On September 26, 2010
Prevent Overstretching By Debts!
First of all, I have to consider that there are two kinds of debt, good debt and bad debt. A bad debt is one that needs to be paid off by me. In good debt, someone else is paying off my debt as learned from the Rich Dad’s series by Robert Kiyosaki. Good debt can be used to invest in assets that generate positive cash flow.
For example, I can borrow money to invest in a piece of real estate and rent it out. As long as my monthly rental income is more than my monthly mortgage repayment amount, then I do not need to pay the mortgage myself. My tenant will be the one paying for my debt.
If I keep repeating the process of investing in real estates by using good debt, then potentially I can earn a lot more money and gained a lot of properties. But there is a catch. I will have a lot of good debts that can potentially turns into bad debts anytime. This can be due to the fact that my tenants quit renting the properties from me.
In other words, there is always a risk that I will become overstretched by bad debts. As a result of overstretching, I will not be able to pay off my debts and need to be declared as bankrupt. Since there is such as risk, I need to prevent it by not becoming overstretched by debts.
How to determine whether I am overstretched by debts?
Based on my understanding from financial education, I feel that I can use a few personal financial ratios to evaluate whether I am overstretched. The first ratio that I will use is the ‘debt service’ ratio. This ratio measures my capability to service my debt.
To calculate the ‘debt service ratio’, I need work out my income and expenditure statement. My ‘income and expenditure statement’ records all my income and expenses for a year. From the statement, I will know my total income.
Next, I can derive my total debt repayments from the ‘income and expenditure statement’. They are recorded as expenses such as mortgage repayment, car loan repayment and so on.
Lastly, I will divide ‘total debt repayment’ by my ‘total income’ to get the ‘debt to income’ ratio. If my ‘debt to income ratio’ is less than or equal to 0.35 or 35%, then I am considered to be carrying a healthy debt load. If my ratio is higher than 0.35 or 35%, then I am overstretched. I should stop taking on any more debt but start paying off the debt.
The next ratio that I will use will be ‘solvency’ ratio. The first step that I need to do is to work out my personal balance sheet for the same period. My balance sheet records all my assets and liabilities. The difference between my total assets and my total liabilities is my net worth. If my net worth is already negative, then that mean I am already seriously in debt. I should start reducing my debt.
Divide my net worth by my total assets I will get the ‘solvency’ ratio. This ratio indicates how much decline in value of my asset before I become insolvent. The higher the ratio, the better position I will be in. Being insolvent means that my total liabilities will be more than my total assets.
In addition, I will also look at ‘debt to assets’ ratio. To derive this ratio, I need to divide my total liabilities by my total assets. This ratio measures my solvency or my ability to pay debt. My ‘debt to assets’ ratio should be lower than the advisable limit of 50%. It is possible to have enough current income to pay my bills but not enough assets to cover all my debts. If this is the case, I am excessively in debt and technically insolvent, which can eventually lead to bankruptcy.
The last ratio that I will look at is the ‘basic liquidity ratio’. This ratio is calculated by diving my total cash or near cash assets by my total expenditure. My total cash or near cash assets is available from my ‘income and expenditure statement’. This ratio shows the number of month that I can continue to meet my expenses from cash or near cash assets if all of my sources of income are lost.
As a thumb of rule, I should have a ratio of around 3 to 6. That is my cash or near cash assets can sustain me at between 3 to 6 months. And I can look for alternative source of income during this period.
Please note that the usage of the above ratios to gauge whether I am overstretched by debts is purely based on my personal opinion. I am not providing any financial advice here. If you study more about financial planning, you probably can find more ratios or ways to decide whether you are overstretched by debts. That is why financial education highlighted in the Rich Dad series by Robert Kiyosaki as one of the three essential educations that allow one to achieve financial freedom.
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