This is how to do personal financial math; your result might surprise you.
Personal finance is all about controlling risk while preparing for and allocating cash flow to fulfill financial goals. Income, expenses, assets, and obligations are all included under personal finance. It aims to answer money-related questions such as how much liquidity is appropriate for you. How much money should you put aside there?
We’ll look at various personal finance measures and how to calculate them this week. You may make these calculations on an excel sheet or a calculator; all you need is the raw data. (No algebra here.)
Savings is both the beginning and the most difficult part of any financial journey. You have saved when you earn but do not spend. Savings are necessary for investment, so salvation aims to ensure that when our income rises, so does our savings rate. The goal is to save a percentage of revenue rather than a fixed amount, so the intention is to save 5% of revenue rather than a fixed amount. The Savings Rate, which is essentially a savings to total revenue ratio, is the measurable goal. If you earn N1000 and spend N900, you have a 10-percentage-point savings rate, which is calculated as
(Savings/Total Income) x 100; (100/1000) x 100 = 10%
Not sure what savings rate to use? The general rule is to save 10% of your salary. However, this should not be done if your budget is already stretched. Instead, start small and adjust your budget to cut costs or increase income to accomplish your savings goals. A higher savings rate is preferable since it provides you with a tool (cash) with which to invest.
Keeping a comprehensive spending notebook, potentially using an app like Modify, is a beneficial exercise since it allows you to look back and identify where you can make savings adjustments to increase your savings rate.
The flow of funds:
Cash flow is simply the difference between how much you earn and spend. In other words, are you living within your financial means? Your cash flow will be raised if you have a high savings rate; if your saving rate is low or negative, your cash flow will be negative. Cash flow is simple to calculate: all-cash inflow minus all cash outflow. (Notice the emphasis on the word cash.)
Remember that debt is revenue to you; therefore, when calculating cash flow, make careful to deduct the cost of any debt used to obtain the cash. A positive cash flow is an objective.
As the name says, an emergency fund is set up to address unforeseen circumstances that necessitate financial assistance to resolve a medical emergency. Having emergency reserves allows you to avoid liquidating your financial portfolio to cover an unexpected expense.
An emergency reserve of 3-6 months of non-discretionary needs, such as food and rent, is recommended. The emergency fund is typically made up of cash or cash-like items.
To calculate an emergency fund, divide liquid assets by monthly non-discretionary costs. Assume that we estimate non-discretionary spending to be $100,000 per month and that we have $300,000 in cash assets. The ratio of our emergency fund will be 300,000/100,000, or 3. This suggests the funds are sufficient to cover three months of emergency spending without requiring more funds. The key to this equation is determining “non-Discretionary” expenses correctly and accurately. A three-to-one emergency savings ratio is ideal.
It’s a simple calculation: your net worth equals your total assets minus your total liabilities.
The hard part is organizing your assets and categorizing them as income-generating and non-income-generating. Thus, a flat you own and rent out is an income-generating asset, whereas a gold watch is not. Similarly, a car you acknowledge that you acquired with a bank loan is an interest-bearing liability. A zero-interest loan from your employer, on the other hand, will constitute a non-interest-bearing liability.
Then, arrange those categories in order of most liquid to least liquid. As a result, cash in the bank will take precedence over a corporate bond. Credit card debt will arrive before the principal repayment of a bond you issued for liabilities, and you’ll have to net it out. As an anchor on my networth sheet, I always compare what I get from my income-producing assets against what I pay on the obligation side.
Debt-to-Asset Ratio (D/A):
It’s critical to keep track of your debt. Debt permits you to buy assets without having to spend cash. Because the cash cost of some things, such as a home, is so expensive, it makes sense to leverage up to buy it. Debt should only be used to purchase assets that create revenue or reduce a current expense. The Debt to Asset Ratio is determined as Total Liabilities divided by Total Assets given as a percentage.
If your total liabilities are $25 million and your total assets are $30 million, your debt ratio is 25/30, or 83 percent, meaning debt is financing 83 percent of your help. The goal with debt is to reduce the amount owed steadily, and your interest-bearing debt should be drastically decreased or eliminated as you get closer to retirement.
Debt Coverage Ratio: This indicates how well your cash income covers your debt commitments. For example, your debt coverage ratio will be if you earn $100,000 per month and have two loans: a $2500 auto loan and a $2,000 mortgage.
100,000/4500, or 22 times the amount covered.
This means that the total money received is enough to cover the interest payments. This is excellent. A low or negative coverage ratio means that your current cash income is insufficient to cover or repay your debt.
The long-term debt to Gross Income ratio is another debt-to-income measure. This computation determines how much of your gross income can be set aside for debt repayment over a longer period, such as a mortgage. Most mortgage providers will use a variation of this method to grade your mortgage application. This calculation is based on the assumption that only a set percentage of your gross income can be used to repay long-term debt.
Assume a mortgage firm has a 30 percent debt-to-gross-income hurdle rate, implying you can only use 30 percent of your gross income to pay down the loan. In other words, if 30% of your payment is insufficient to cover your monthly mortgage requirement, you will be denied the loan.
Finally, there’s the 72-hour rule. This is a simple trick to master. Divide the rate of return on any investment by 72 to find out how long it will take for that investment to double your money.
For example, if I invest N10 million in a ten-room apartment building, I should expect to make an 8% return on the rental property. When will my N10m be doubled?
I divide 72/8 or 9 years using the 72 rule.
Remember that the purpose of these computations is to help you track your progress toward a specific objective. These rations can assist you in modifying your spending or investment behavior if implemented correctly and early. You already know that if you want to buy a house, you’ll need to pay off your other long-term debts to free up enough cash to keep your mortgage payments below the lenders’ recommended hurdle rate.