December 27, 2013 in Investing

6 financial formulas to help you succeed

6 formulas to help you succeed

If you’re like most people, you’ve got the basics of personal finance under control: balancing the checkbook, keeping on top of bills. But beyond that are more sophisticated financial concepts that can help you make better financial decisions — if you know how to do the math.

Unfortunately, if you’re not confident that you understand the numbers, then it’s hard to be confident that you’re making good financial decisions. Certified Financial Planner Jeffrey Golden of Circle Advisers in New York City points out that an older person can feel vulnerable if he or she doesn’t know how viable her financial plans are, whereas a younger person might put off decision-making. “These simple rules of thumb can help make the light bulb go off” about making smart financial decisions, he says.

To help you build your confidence in your financial decision-making, we’ve collected some of the most important financial formulas here — along with explanations about how to use them. Get out your calculator and let the crunching begin!

Formula No. 1: Calculate your cash flow

This straightforward financial formula is key to your success.

Subtract your expenses from your income to get your cash flow. “This calculation is going to help you understand your true living expenses,” Golden says.

A negative cash flow means you’re spending more than you bring in. This may deplete your savings or increase your debt. A positive cash flow indicates that you’re 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.

“Knowing if there is potential leftover income could be helpful in terms of thinking about extra savings you can make to grow a nest egg,” says Golden. “What I’ve come to discover is that people who do not have a good sense of their cash flow underestimate their ability to save.”

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 property taxes, auto insurance and vacations, as well as unscheduled (but not unexpected) expenses like that co-pay for the doctor or that shower present for your co-worker.

Formula No. 2: Find leverage ratio using income

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 and of itself isn’t a bad thing. It’s when your debt is too great in proportion to your income where you can get into trouble.

Here, 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 says that your leverage ratio (including mortgage, car loans, etc.) should be no more than 33 percent of your income.

Stephen Lovell, president of Lovell Wealth Legacy, a registered investment adviser, says the leverage ratio is also useful in determining your coverage ratio; that is to say, how many times you can 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.

“If you took a financial hit (such as unemployment or disability), you could continue to pay the mortgage,” he says.

Formula No. 3: Find leverage ratio using equity

You can also find the leverage ratio for your liabilities compared to your equity (rather than income). Equity, simply put, is 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. Stocks are also equities.

Using this leverage ratio “lets you know how much risk you currently have,” says Lovell. It’s a quick way to see how at risk your debt is, a calculation you may want to make before you take 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 need to make sure your leverage ratio is lower. Someone with more assets can have a higher ratio.

Formula No. 4: Calculate inflation-adjusted return

You know that investments have to do more than keep pace with inflation for you 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 helps you 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’d set up the problem:

[(1.08 ÷ 1.03) – 1] x 100 = 4.85 percent real return

“You’re losing to inflation every year,” says Charles Sachs, a wealth manager at Private Wealth Counsel in Miami. “Long term, inflation runs about 3 percent. So your money buys half as much in 20 years.”

In other words, leaving your money stuffed 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 likely to be.

Formula No. 5: Calculate your gains (or losses)

You’re invested in a blue-chip stock, and you’d like to know how much, in percentage terms, your investment has increased so that you can finally get your brother-in-law to quit yapping about the killer returns he’s going to realize on his ill-advised investment in desert-front property in Arizona.

Using the formula, say you bought the blue-chip stock at $60, and now it’s trading for $100:

($100 – $60) ÷ $60 = 67 percent gain

You can prove that you’re one smart cookie.

If, on the other hand, you listened to your brother-in-law’s sales spiel about the property in Arizona, your investment has gone down in value. By how much? You just switch up the formula a little:

(Purchase price – Market price) ÷ Purchase price = Percentage decrease

Suppose you bought shares in an Arizona-focused real estate investment trust at $200 and it’s now selling for $100:

($200 – $100) ÷ $200 = 50 percent loss

Sorry about your loss!

Formula No. 6: How long to double your money

This “Rule of 72” helps you quickly compare the returns from different interest rates, taking into account the effect of compounding.

If you have a sum of money now, you can quickly estimate how much it will grow to be in the future. For example, if you take $10,000 and invest it at 5 percent, then this rule of thumb tells you it will take about 14.4 years to double your money.

“That helps people think about how long they’ll need to work. It makes a good starting point for evaluating your current situation,” says Golden.

Sachs cautions that there’s a drawback to focusing on return: “What if you met your target return but not your financial goals?” He suggests deciding on your goals first and then building a portfolio that can meet those goals with the least amount of risk.

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