Okay, you’re doing all the things that you should do to keep your personal finances under control. You have a budget, you’re keeping up on your bills and you balance your checkbook religiously. Beyond these basics there are some other high-level concepts that could help you make healthier financial decisions – if you just know how to do the math. So, if you want to do better financial decision-making, here are six of the most important financial formulas, plus explanations as to how to use them.
1. Calculating cash flow
This is a very straightforward formula but can be the key to your success. It’s Income minus Expenses equals Cash flow. As you can see, this is pretty simple. All you need to do is subtract your expenses from your income and you’ll know your cash flow. The purpose of this is to help you understand your real living expenses. If you find that you have a negative cash flow, you’re spending more than your income. This will either reduce your savings or increase your debt. On the other hand, a positive cash flow means that you’re living well within your means. In the event you find that you have a negative cash flow, you need to take whatever steps you could to reduce your expenses or find ways to earn more money.
2. Find leverage ratio using income
This formula is Debt payments divided by Income equals Leverage ratio. In this case, the term “leverage” refers to the use of borrowed capital – or debt. Most of us use leverage to buy a house, which is why we end up with a mortgage. So, by itself leverage is not necessarily a bad thing. It’s bad only when your debt is too big in proportion to your income. Be sure you compare similar time frames. If you’re looking at monthly debt payments, you need to use your monthly income as the divisor. The common rule of thumb is that your leverage ratio – including car loans, your mortgage, etc. – should be no more than 33% of your income.
3. Find leverage ratio using equity
You can find the leverage ratio for your liabilities in comparison with your equity – instead of your income. This formula is Total debtdivided by Total equity equals Leverage ratio. Another way to put this is to call it ownership interest. For instance, let’s suppose your house is worth $200,000 and your mortgage is for $50,000. In this case you would have equity of $150,000 in the house. Stocks are other equities. When you use this ratio, you can see how much risk you currently have. It’s a fast way to learn how at risk is your equity. You may want to make this calculation before you take on other financial risks, such as going back to school or changing jobs.
4. Calculate inflation-adjusted returns
You probably already know about inflation and that if you have investments they need to do more than keep pace with it if you want to build wealth. The simple way to explain this is that a dollar today is not worth the same as a dollar in the future. But how could you calculate what your investment return will be after inflation? This gets a bit complex. The formula is:
(1 + investment return) divided by (1 + inflation rate rate) – 1 x 100 = real return
As an example of how this works if you had an investment that returned 8% and inflation was at 3%, you’d have a 4.85% real return and would be losing to inflation every year. In fact, after 20 years you would be able to buy only about half of what you could buy today with the same money.
5. Calculate your gains (or losses)
If you’ve invested in a stock and would like to know how much your investment has increased so far here is the formula.
(Market price – purchase price) divided by purchase price = percentage increase
In the event that you bought that stock at $60 and it’s now trading for $100, this formula would translate into: ($100 – $60) $60 = 67% gain
6. How long would it take to double your money?
You could quickly compare the returns you would get given different interest rates using the “Rule of 72.”
It’s 72 divided by R (the annual interest rate of the investment) = Years to double investment
Other tips for being a better money manager
While these six formulas could help you better know how you stand financially, there are some other important things you need to do to be a top-flight money manager. The most important of these is to keep your finances under control by making sure you don’t have too much debt. How much is too much? There’s an easy way to answer this question. Just add up all your fixed monthly debts such as your rent or mortgage payment, your auto loan(s) and your credit card payments. Next, add up all your monthly income. If you earn a commission, be sure to include it. If you get an annual bonus or a nice Christmas check from Aunt Margaret, divide it by 12 and add that to your monthly income. Finally, divide your total monthly income into your monthly debt. This yields your debt-to-income ratio. For example, if your monthly income is $5,000 and your monthly debt is $2,000, your debt-to-income ratio would be 40% ($2,000 ÷$5000), which experts would say is too high.
What to do is you have a bad debt-to-income ratio
Most experts believe that your debt-to-income ratio should be no higher than 30%. If yours is higher than this, you have two choices. You could find ways to cut your other expenses and use the money to pay down some of your debts or you could look for ways to increase your income. Here’s a brief video with some good tips for cutting your spending.
Many people choose to increase their incomes by getting a second job or by adding a second shift where they work. There are almost always part time jobs available in the hospitality and food service industries. These jobs usually pay $10 an hour or less but if you were to work an extra 15 hours a week and apply all your earnings to paying down your debt, you’d probably have that debt-to-income ratio down to less than 30% in just several months.
If you aren’t able to take on a second job, there are numerous other ways to increase your income. For example, you might be able to make and sell crafts on the site Etsy, tutor students, do childcare, become a nanny, do handyman jobs, have a massive garage sale or sell stuff on eBay or Amazon. Yes, Amazon. It’s an excellent marketplace and a great way to sell things if you don’t want to fool around with auctions as everything is a fixed price. As an example of this, here’s a recent listing on Amazon for an Apple MacBook.
Apple MacBook Pro MD101LL/A 13.3-Inch Laptop (NEWEST VERSION)
• In Stock
• More Buying Choices
• $1,149.99 new (3 offers)
• $799.95 used (107 offers)
Notice the “More Buying Choices” and the “$799.95 used.” If you were to click on that link, you’d find 107 companies and individuals selling MacBooks. If you have items you could sell that are in good shape, you could list them on either Amazon or eBay and increase your income just about overnight. And if you stop to think about it, there are probably at least a dozen other ways you could earn extra money and get that debt-to-income ratio down to 30% or even a lot less.