Important financial formulas for investors
The world of finance can seem complex, but many of the concepts are simpler than they seem at first glance. Understanding your income and expenses and mapping your investment returns can help you take control of your financial life. These six formulas 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 the money coming in and going out. This simple cash flow formula is the key to your success.
Cash flow = income – expenses
A negative cash flow means that you spend more than you bring in. This can deplete your savings or increase your debt. A positive cash flow indicates that you are living within your means. If the result is negative cash flow, you can take steps to reduce your expenses or find additional sources of income.
“Knowing whether there may be residual income can be helpful as you think about additional savings you can make to grow a nest egg,” says Jeffrey Golden, a financial planner at Circle Advisers in New York. “What I’ve come to discover is that people who don’t have a good understanding of their cash flow underestimate their ability to save.”
To get the most accurate picture of your expenses, calculate your cash flow over several months and don’t forget to include incidentals such as property taxes, car insurance, and vacations, as well as such unplanned (but not unexpected) expenses. co-payment for the doctor or birthday presents for your family.
2. Leverage ratio (2 formulas)
The term ‘leverage’ means the use of borrowed capital – debt. Most people use leverage to buy a house. That’s why you have a mortgage. So leverage in itself is not a bad thing. If your debt is too high in relation to your income, you could get into trouble.
Here you need to compare similar time frames, so when looking at your monthly debt payments, you should use your monthly income as the divisor. A general rule of thumb says that your leverage ratio (including mortgage, car loans, etc.) should not exceed 33 percent of your income.
Stephen Lovell, president of Lovell Wealth Management, a registered investment advisor, says the leverage ratio is also useful in determining your coverage ratio. That is, how many times can you pay off your debts 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 four times the coverage.
You can also compare the leverage ratio of your liabilities with your equity (instead of income). Simply put, equity is your ownership interest. For example, if your house is worth $200,000 and you owe $50,000, you have $150,000 equity in the house.
Using this leverage ratio “tells you how much risk you currently have,” Lovell says. It’s a quick way to see how much risk your debts are; a calculation you may want to make before taking other financial risks, such as changing jobs or going back to school.
The lower the ratio, the better your overall financial health. Lovell points out that if you have fewer assets, you should make sure your leverage ratio is lower. Someone with more assets may have a higher ratio because he/she has more ability to pay off that leverage with the additional assets.
3. Inflation-adjusted return
You know that investments must do more than keep pace with inflation to build wealth. As Golden says, “A dollar today is not worth a dollar in the future.” But how do you determine what your investment return is after inflation?
This equation allows you to calculate your actual return, or your return adjusted for inflation. For example, if an investment yields an 8 percent return and inflation is 3 percent, you can solve the problem as follows:
[ ( 1.08 ÷ 1.03 ) – 1 ] x 100 = 4.85 percent real return
“Every year you lose because of inflation,” says Charles Sachs, an asset manager at Kaufman Rossin Wealth in Miami. “In the long run, inflation is about 3 percent. So with your money you can buy half of it in twenty years.”
In other words, leaving your money under your mattress creates a real risk that you will have significantly less purchasing power than if you had invested it. By calculating your actual return, you can find out what your future purchasing power is likely to be.
4. Calculate profit or loss
Let’s say you’re invested in top stocks like Walmart or Microsoft, and you want to know how much, percentage-wise, your investment has increased.
Use the formula: suppose you bought the stock for $60 and it is now trading for $100:
($100 – $60) ÷ $60 = 67 percent profit
On the other hand, if you bought a popular cryptocurrency like Bitcoin near its peak, you experienced a drop in value. To find out exactly how much you lost requires a slight change in the formula:
(Purchase price – Market price) ÷ Purchase price = Percentage decrease
Suppose you bought Bitcoin for $60,000 and it is now selling for $30,000:
($60,000 – $30,000) ÷ $60,000 = 50.0 percent loss
5. Rule of 72
The ‘Rule of 72’ allows you to quickly compare returns from different interest rates, taking into account the effect of compound interest rates. You can quickly see how long it will take for your money to double at a certain return level.
For example, if you take $10,000 and invest it at 5 percent, this rule of thumb tells you that it will take about 14.4 years to double your money.
“That helps people think about how long they have to work. It’s a good starting point for evaluating your current situation,” says Golden.
Sachs warns that there is a downside to focusing on returns: “What if you achieved your target returns, but not your financial goals?” He suggests determining your goals first and then building a portfolio that can achieve those goals with the least risk.
