Today we are frequently faced with the need to make financial decisions whether in investments, business, or debt management. So it remains perplexing why our schools don’t teach financial formulas in the same way they engrave Pythagoras Theorem in young minds. This explains in a large part why the average investor loses in the stock market, and is faced with risks in the mismanagement of business and debt. Simply put, financial illiteracy can cost us more money if we maintain a “trial by fire” approach. As savvy investors, you should at least know the ten basic financial equations for investment, business, and debt in order to take better care of your financial future.
The financial world has changed greatly over the last forty years. For instance, in the late 1970s and early 1980s, the average rate on a one-month certificate of deposit ranged between 11-16 percent. This meant that investors could gain a sufficient amount of return by keeping it safe at the bank, and no one needed the capital markets then. However, today the average one-month deposit is 0.1 percent, which raises the need to invest in the capital markets to keep up at least with inflation and the rise of the cost of living. Thus, for both the rich and poor alike, investing is a necessity, rather than a luxury. The good news is that in the last 25 years technology has progressed exponentially to make investment markets accessible to the retail investor. In turn, this means we need to sieve through what seems like an endless torrent of information in order to get the knowledge that guides us on what to buy and sell, or how to manage debt risk.
In this respect it is useful to observe the achievements of Warren Buffett, who is widely considered the most successful investor of the twentieth century at a net worth of $53.5 billion, and fourth on the Forbes list of billionaires which was announced in March. Through Berkshire Hathaway, of whom he is the primary shareholder, chairman, and CEO, Buffett somehow managed to deliver a 200 percent return just between 2002 and 2012 – which trounced the 30 percent rise in inflation over the same period. This was achieved by approaching investments as a business and buying into well managed companies like American Express, Coca-Cola, IBM, Wells Fargo, and, most recently, Heinz whose huge deal was announced in February.
In his approach to investments, Buffett resorts to simple equations to value the company, measure its risk, and assess the effectiveness of its management. Notably, Buffett does not use a computer to this day. He started investing when he was 11-years-old in 1941, before calculators had even come to the market. During his professional investment career he further developed his valuation prowess but preserved his overall analytical simplicity. In his latest annual report for 2012, Buffett defines intrinsic value as “the discounted value of the cash that can be taken out of the business during its remaining life”. However, he also admits that calculation of the intrinsic value is an estimate at best, and needs to be constantly revised with the changing interest rates and actual results of the business. Due to the dynamic nature of the analysis, it is essential for the savvy investor to have a solid financial awareness of the world. Allow me to present to you the top ten formulas that will help you safely navigate the financial world, and stop you from falling prey to the whims of analysts, bankers, and so-called “gurus”.
The essential equations to know in investments are the dividend growth model, and the cash flow valuation. The dividend growth model equation is the formula that defines intrinsic valuation on a constant growth assumption basis, whilst the cash flow valuation calculates the time value of money. The annuity equation is less used in investments, but more in terms of retirement planning. As such, the annuity equation can help in deciding whether to accept a periodic payment, or a lump sum of money at retirement.
As for businesses, whether investing in them or managing your own, four equations need to be kept in mind at all times. The breakeven point equation calculates the sales target needed to be reached in order to cover the total fixed and variable cost of the business. The cash conversion cycle provides the insight into how efficient cash is managed, and the current ratio measure the liquidity risk of the business. As an overall assessment of the business, the Dupont analysis converts the profitability on the equity to its component of profit margin, sales per asset, and leverage ratios.
However, the debt equations are the most important of these equations since debt represents a legal obligation on the debtor to pay the lender in cash both the interest and principal. The debt payment equation calculates the monthly payment needed to cover the principal and interest for a loan. Debt service coverage ratio measures the ability of the company or individual to pay the interest payment. Usually, this ratio should be above 1.3 for a loan to be considered by a bank.
The credit card equation provides the length of time that is needed to pay off the credit card. For example, if the debtor only pays the minimum $100 per month for a $5,000 loan at a rate of 22 percent, it will take 11.2 years to pay it off. This is seven years longer compared to the simple math of dividing the loan $5,000 by the amount paid of $100, which gives 50 months or 4.2 years.
Burden of debt
The importance of proper management of your own debt is essential for life. In fact, the British Office for National Statistics, and British suicide prevention experts linked a significant recent increase of suicides in the UK to irresponsible lending practices and predatory collections. The recently issued report mentioned that debtors frequently felt humiliated, disconnected, and entrapped.
Canada is known to have one of the highest rates of insolvencies amongst the Western economies. This is blamed on the ease of declaring bankruptcy to escape debt and other obligations whether as a business or individual. This led the lawmakers to institute a mandatory requirement that before declaring bankruptcy the debtor is obligated to receive credit counseling, and even commit to pay off debt with any surplus income.
These reactions assumes that the debtor is the only one to be blamed, and omits the responsibility of the lender in granting credit. It remains the responsibility of the lender to adequately review the ability of the debtor to pay back the loan principal and interest. Traditionally, this was done by reviewing the five Cs of credit: character, capacity, capital, collateral, and conditions. However, in order to speed up the lending process, the full review was replaced with a sole reliance on the credit score, which is the main culprit in the malaise of lending. Hardly anyone realizes that your credit score actually improves when your ability to repay decreases – typically when you only pay the monthly minimum, and use more than one credit card.
This called for a consumer advocacy in Canada to abandon the dependency on the credit score to lend credit, but rather to provide a more comprehensive review of the ability of the debtor – a more time consuming process that banks are less likely to complete if they were not obligated to do so.