Useful Numbers and Financial Ratios

Introduction

Some numbers and ratios are very useful in financial planning. They enable you to set realistic and achievable financial goals. They also help you quantify your financial aspirations and make it easy to navigate through the challenges that come your way. You can make correct financial decisions with the help of these numbers and ratios.

Record Keeping

In order to incorporate these numbers and ratios into your financial planning, it is important to take following steps:

• Log all your financial transactions (income and expenses) in a secure way, on a daily basis, so that you can refer back to this record whenever it is necessary. You may use a software or a mobile app for this.
• Then regularly consolidate this record into following yearly statements:
  • Balance sheet.
  • Income statement.
  • Cash flow statement.

Useful Numbers and Financial Ratios

Net Worth

Net worth is what you get when you subtract the liabilities from your assets. The financial formula is as under:

Net Worth = Assets – Liabilities

The difference between what you own and what you owe is your net worth. This is a very useful number. It helps you take financial decisions correctly, especially when you buy big-ticket items like a house or an automobile. Before making a purchase decision, it is very wise to see the expense in question as a percentage of your net worth. As a guideline, the total cost of your automobile(s) should not be more than 5-7% of your net worth whereas your house may be equal in cost to 15-25% of your net worth. If a substantial proportion of your net worth goes into buying these non-productive assets, Robert Kiyosaki even calls them liabilities, your financial health will become correspondingly weak. Resultantly, you will have to work for longer years, in addition to becoming vulnerable to financial upheavals, and your retirement will be delayed inordinately.

The Rule of 72

This is a rough rule. Through this, you can easily find out how many years it will take to double your money, if you compound it at a certain rate. You get the number of years needed for this by dividing 72 with the number of years involved. For example, if you compound your money at 9% per annum, it will take 8 (72 / 9 = 8) years to double.

Conversely, if you want to double your money in a fixed number of years, you can find out the rate at which you must compound your money. For example, if you want to double your money in 6 years, the required rate of compounding per annum will be 12% (72 / 6 = 12).

Compounded Annual Growth Rate (CAGR)

Compounding is extremely powerful. It is the best framework for long-term wealth creation. You should prefer to invest in long-term wealth compounders. The power of compounding can be illustrated with the help of following example:

• If you compound your wealth at 26% CAGR for 10 years, it will become 10x (10 times increase).
• Whereas 26% CAGR for 20 years will be 100x!
• 26% CAGR for 30 years will be 1000x!!
• 26% CAGR for 40 years will be 10000x!!!
• …. and so on.

The 50-30-20 Rule

This rule is about how you should divide your monthly income into various buckets. This may be taken as a broad guideline only. You should create three buckets for your income i.e. needs, wants, and savings.

You should try to fulfill your needs with 50% of your monthly income. Your wants and desires can take another 30%. Whereas, the remaining 20% should be saved and invested on a long-term basis.

Price to Earning (P/E) Ratio

This ratio is normally used while investing in the stock market. However, it is very useful for other types of investments as well. It gives you a sense of how cheap or expensive a particular investment option is, relative to its earnings. However, it should not be used in isolation.

If the price of a share is 100 and its annual earning is 10, the P/E ratio will be 10x (100 / 10 = 10). A higher P/E ratio implies that the investment is expensive as compared to the one with a lower P/E.

If you want to compare rental yields of residential and commercial real estate with those of various businesses in the stock market, you can make use of this ratio.

The 4% Rule

This rule is useful when you want to find out how much money you would need in order to retire from work and become financially free. Let me explain it with the help of an example.

Let’s say you need 100 thousand per month to live comfortably without working for money. That means your annual requirement is 1200 thousand. Through the 4% rule, you can work out how much you would need to invest in a lump sum to retire. This comes to 1200 x 1000 x 100 / 4 = 30,000,000. If you invest 30,000,000/- in stable businesses which pay good dividends regularly, you can expect a steady income that can fulfill your financial needs.

Even if you want to cater to approximately 7% annual inflation, this arrangement can work. That means you can draw 7% more every year.

Your portfolio will remain stable if it is earning around 12% every year, on average, which is achievable.

Conclusion

We should always try to embed financial numbers and ratios in our thought process. It will help us think clearly and make rational decisions.