The financial world can seem complex, but many of the concepts are simpler than they first appear. Understanding your income and expenses, and figuring out your investment returns can help you get control of your financial life. Here are six formulas that can help you better understand your financial life and lead to better decision-making.
1. Cash flow
It’s hard to understand how much you’re saving until you know what cash is coming in and going out. This straightforward cash flow formula is key to your success.
Cash flow = Income – Expenses
A negative cash flow means you are spending more than you bring in. This may deplete your savings or increase your debt. A positive cash flow indicates that you are living within your means. If the result is a negative cash flow, you can take steps to reduce your expenses or seek additional sources of income.
People who do not have a good sense of cash flow underestimate their ability to save.
Knowing there is potential leftover income could be helpful in terms of thinking about extra savings to grow a nest egg
To get the most accurate picture of your expenses, calculate your cash flow over a number of months, and don’t forget to include occasional expenses such as taxes, insurance, and vacations, as well as unscheduled (but not unexpected) expenses) for your family.
2. Leverage ratio (2 formulas)
The term “leverage” means using borrowed capital — debt. Most people use leverage to buy a house — that’s why you have a mortgage. So, leverage in and of itself isn’t a bad thing. It’s when your debt is too great in proportion to your income, that’s when you get into trouble.
You need to compare similar time frames, so if you’re looking at your monthly debt payments, you need to use your monthly income as the divisor.
A common rule of thumb is your leverage ratio (including mortgage, car loans, etc.) should be no more than 33 percent of your income.
Financial experts say that the leverage ratio is also useful in determining your coverage ratio.
It means how many times can you cover your debt per month? For example, if your total debt payment per month is $1,000 and your monthly income is $4,000, then that’s a good ratio — you have 4 times the coverage.
You can also find the leverage ratio for your liabilities compared to your equity (rather than income). Equity, simply put, is your ownership interest.
For example, if your house is worth $200,000 and you owe $50,000, then you have equity of $150,000 in the house.
Using the leverage ratio lets you know how much risk you currently have.
It’s a quick way to see how risky your debt is, a calculation that you may want to make before taking other financial risks — such as changing jobs or taking a no-pay leave to pursue your education.
The lower the ratio, the better your overall financial health. If you have fewer assets, you need to make sure your leverage ratio is lower.
Someone with more assets can have a higher ratio because they have more ability to pay down that leverage with the extra assets.
3. Inflation-adjusted returns
A dollar today is not worth a dollar in the future.
But how do you determine what your investment return is after inflation?
Investments have to do more than keeping pace with inflation for you to build your wealth.
This equation also helps you to compute your real return or your return adjusted for inflation.
For example, if an investment returns 8 percent, and inflation is 3 percent, this is how you would set up the problem:
[(1.08 ÷ 1.03) – 1] x 100 = 4.85 percent real return.
The fact is we are losing to inflation every year. Long-term inflation runs about three percent. So, your money buys half as much in 20 years.
In other words, leaving your money under your mattress creates a real risk that you’ll have significantly less purchasing power than if you had invested it.
Calculating your real return helps you figure out what your future purchasing power is like.
4. Calculate gains or losses
If you have invested in a blue-chip stock such as Walmart or Microsoft, and you’d like to know how much in percentage terms, your investment has increased.
Using the formula, say you have bought the stock at $60, and now it’s trading for $100:
($100 – $60) ÷ $60 = 67 percent gain.
If, on the other hand, you purchased Bitcoin near the peak, you’ve experienced a decline in value.
Figuring out exactly how much you’ve lost requires a slight change to the formula:
(Purchase price – Market price) ÷ Purchase price = Percentage decrease
For example, if you bought Bitcoin at $60,000 and it’s now selling for $22,000: ($60,000 – $22,000) ÷ $60,000 = 63.3 percent loss
5. Rule of 72
The “Rule of 72” helps you compare the returns from different interest rates taking into account the effect of compounding.
You’ll be able to see how long it takes for your money to double at any given level of return.
For example, if you take $10,000 and invest at 5 percent, then this rule of thumb says that it will take about 14.4 years to double up your money.
This formula will help you think about how long you will need to work, which makes a good starting point for evaluating your current situation.
But what if you’ve met your target returns but not your financial goals?
It is better to decide on your financial goals first, and then build a portfolio that can meet those goals with the least amount of risk.