The most important formulas in Personal Finance

Do we need math skills in personal finance and investing? 

Financial success is 80% about soft skills (mindset) and 20% about technical skills. Still, that 20% is indispensable: it is a conditio sine qua non. Luckily, you don’t need to be math geeks; you need to keep it simple and rely on basic arithmetic calculations. Even the Great Investor Warren Buffett made this clearInvestors should be sceptical of [complex] history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.” In fact, even if there is always the risk and/or pleasure of building complex models, personal finance and investing can be successfully managed with a simple “back of the envelope calculation”. 

I hereby share my top 9 personal finance formulas:

1) Net Income (Profit or Loss) = Total Revenues – Total Costs 

With this formula, you look at the “bottom line”: are you making a profit?

Example: $100,000 (Revenues) – $60,000 (Total costs) = $40,000 (Net Income & saving)

Investment tip: no matter how simple this formula looks like, the main principle of Personal Finance relies on it: spend less than you earn and invest the difference.

2) Burn Rate = (Total costs / Total Revenues)%

The Burn Rate provides an immediate indicator of how much you spend annually as a percentage of total revenues. Clearly, you need to keep this percentage under control: are you consciously spending on valuable products and services or not? Are you falling into lifestyle creep? Are you taking unnecessary debt? By controlling and optimizing the outcomes of this formula, you already have resources to save (Pay Yourself First) and Invest.

Example: $60,000 (total costs)/ $100,000 (Revenues) = 60% (Burn Rate)

3) The 50 – 30 – 20 rule

This practical formula provides quick guidelines for a personal budget. It suggests allocating 50% of your budget for essentials expenditures like rent and food (needs), 30%  for discretionary spending (wants), and at least 20% for savings. The beauty of this formula is that it provides a simple reference and can be easily adjusted to your specific factors (age, lifestyle and goals).  The initial budget should be equal to the total revenues minus taxes.

Example
Revenues100,000100%
Essentials50,00050%
Wants30,00030%
Savings20,00020%

Investment tips:

(a) while the formula suggests saving at least 20% of your revenues, it is up to you. When you are ready to make the necessary adjustments (reduce overheads, curb “wants”, optimize your habits), you can increase your saving rate (reduce your burn rate) up to 30% or 50%.  Increasing revenues can help increase your disposable income but will not automatically increase your saving rate. Changing your saving rate is a money management choice nearly independent of your revenues.

(b) By investing part of your savings, you will build new revenue streams. This will help you “sweat your assets”, “giving every dollar a job“.

 

4) Rule of 72

The rule of 72 calculates the number of years it will take to double your money with your investment’s expected interest rate (r). This formula is used to obtain a quick approximation for comparisons among different investments products or investment decisions.

Formula: 72/ r = numbers of years

Example (Investment)

r (interest rate)FormulaYears needed to double your money.
Case (A)5% 72/5 =14.4
Case (B)7%72/7 =10.3
Case (C)10%72/10 =7.2

To know more about the 72/r formula,  read my Financial Workout on How long does it take to double my money.

5) Rule of 25 (or the 4 % withdrawal rate)

The rule of 25 states that by multiplying your estimated annual costs for 25, you will know how much money you need to invest with an average interest rate close to 5% to build enough savings for your retirements (without considering any government support).

Formula: your estimated annual costs * 25 = nest egg needed

The formula is also known through its inversion: when a projected 4% annual withdrawal of your invested nest egg is equal to your annual expenditures, you can fully retire:

Formula: 4% * nest egg = annual expenditures

Example: with annual costs of $65,000, the formula suggested to have investments for $ 1,625,000 ($65,000*25= $1,625,000)

To know more about the assumptions behind the 4% rule, read my Financial Workout on How to calculate my financial freedom number.

 

6) Net Worth

The formula for calculating the Net Worth is straightforward: sum all your Assets (what you own), and deduct all the Liabilities (what you owe):

NET WORTH = ASSETS – LIABILITIES 

The Net Worth  provides:

  • a measure of how wealthy you are. It is much more significant than your income: people can have high-income jobs and be broke simultaneously.
  • a system to record your Assets and Liabilities on a monthly and/or annual basis
  • an insightful snapshot of how you efficiently “save/store” value
  • an indication of where you stand along your financial journey
  • visualization of your financial goal (specific value)
  • a compass to help you choose and monitor the results of your Financial Workouts (costs optimizations and the set-up of new income streams).
  • Data to further calculate your Financial Freedom Number (when your annual passive income cover your annual expenditures).

To know more and start measuring it, read my article on How to calculate my Net Worth.

7) Money as Hours of life equivalent 

An interesting way to look at money is to monitor the net amount of time required to gain it. Using such a proxy allows us to maximize and optimize both time and money.

Option A) Formal hourly rate.

Looking at your job contract or annual revenues, you can identify the hourly rate (ex. $ 25 per hour). Every time we spend, we can think about the equivalent of an hour worked.  

Example:

Step 1: calculate your average annual gross income (ex. $ 100,000).

Step 2: calculate your average annual net income (gross income minus taxes). (ex. 100,000 – $ 35,0000 = 65,000).

Step 3: calculate the average number of hours worked during the year. (ex. 260 days  *8= 2,080 working hours).

Step 4: calculate the Formal hourly rate: $65,000 / 2,080 = $31.25 per hour

Option B) Real hourly rate:

Example:

Step 1: calculate your average annual gross income (ex. $ 100,000).

Step 2: calculate your average annual net income (gross income minus taxes). (ex. 100,000 – $ 35,0000 = 65,000).

Step 3: calculate the average annual job-related costs (ex. training, commuting, formal clothes, etc.=$10,000). We can deduct any expense we would not have incurred by not having to work. (ex. 65,000 – 10,000 = 55,000)

Step 4: calculate the average number of hours worked during the year. (ex. 260 days * 8= 2,080).

Step 5: calculate any extra number of work-related hours spent during the year: extra unpaid hours, business dinners, commuting time, travel time, etc. (ex. 600 hours); add these hours to the total numbers of hours worked.  (2,080 + 600= 2,680).

Step 6: divide the net income by the total hours spent for work related activities: $55,000 / 2,680 = $20.52

Chances are there is a major difference between the Formal hourly rate and the Real hourly rate. Once you factor in time and extra job-related costs, you get a clearer picture of the efficiency of your current job or business.

 

8) A Purchase as Hours of life equivalent 

Money spent on a purchase of item X  / Real hourly rate  =  Hours of life equivalent spent to purchase this product or service. 

This formula shows the real working hours necessary for such a purchase. It is a neat way to evaluate if the transaction of working hours makes sense.

Example (A): Hourly rate of $25; price of a new watch: $350.

Hours of life equivalent: $350/$25= 14 hours of work are required to purchase the watch. Do we still value the purchase? Do we want to adjust the range price of the product?

Example (B): Hourly rate of $25; price of a new car: $35,000.

Hours of life equivalent: $35,000/$25 = 1,400 hours of work are required to purchase the car. Do we still value the purchase?

 

9) The Lifetime Wealth Ratio (LWR) 

The financial blogger J. Money publicized the LWR as follow:

Lifetime Wealth Ratio = Net Worth / Total Lifetime Income

Net Worth = Assets – Liabilities

Assets = everything that you own (i.e. house, car, bank accounts, securities, rental properties, etc.)

Liabilities = everything that you owe to others (i.e. credit card debt, student loan debt, mortgage, etc.)

Total lifetime income = everything you have earned over the years (you can make the case with your gross salary or your net salary).

The formula shows you how much of all the income earned you were able to turn into wealth. The beauty of this formula is that takes into consideration both the stock (wealth) and the flows in your personal finances. Your net worth is a stock (i.e. a snapshot of your accumulated wealth) while your income is a flow (i.e. a measure of how your wealth is changing through time).

This is the ranking system to interpret your LWR:

0%-10%Work to do!
10%-25%Getting there
25-50%You are good
50-100%Excellent
100%-1,000%Wow

 

More formulas to come soon!

In the meantime, Sweat Your Assets.

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