Financial Planning Formulas
As I deepen my knowledge in financial planning, I came to realise that there are many formulas that could help me to assist my clients to understand their financial strengths and weaknesses.
- Saving Ratio (SAR) = Total surplus / Total Gross Income
This formula helps you to measure how much was being saved monthly. A recommended saving ratio is above 20%. The higher the saving ratio, the better the money management skills is. Sometime, it is also an indication of achieving future goals.
- Debt Service Ratio (DSR) = Monthly Commitment / Total Gross Income
40% and above are considered a high risk borrower. In other word, the lower the ratio, the better the debt management is. This is just a guideline, however, different banks has different risk appetites; where the acceptable DSR are varies. DSR % helps to understand how much was the gross income being utilised for debt repayment while to understand the remaining % for other household expenses and savings.
- Solvency Ratio (SOR) = Total Asset / Total Liability
SOR shows the ability of an individual to repay all of his debts or liabilities by using his asset or selling it off in case of unforeseen circumstances. The higher the ratio, the better the company to repay all of the debts and vice versa (default or bankruptcy). If the ratio is less than one, the household is technically insolvent.
- Liquidity Ratio (LR) = Total Liquidity Asset / Monthly Commitment
The ideal ratio is 3 to 6 months of household living expenses, while for company is recommended from 9 to 12 months of living expenses. This ratio represent an individual to settle off its monthly committed repayment by liquidate it assets in the short term (cash, fixed deposit) when faced an emergency or decline in income. If the cash flow provided was annual, just simply divide the LR in order to get the monthly LR.
- Current Ratio (CR) = Total Current Liquidity Asset / Current Liability
It simply mean the ability of an individual to repay his short term liability or due within a year in case of financial emergency or unforeseen circumstance. Less than 1 (for instance 0.8/1) simply means unhealthy, but does not necessarily mean bankrupt or inability to service the debts while above 5 (for instance 5/1) it might interpret as inefficient use of current asset. 2 (for instance 2/1) is just nice, while having asset twice more than its liability.
CR & LR might looks similar, but the main differences are CR is mainly for 12 months and above while LR focus it focal point on short terms debts.
- Leverage Ratio or Geared Ratio = Total Debt or Liability / Total Asset or Net Worth
The ratio equal to 1 or lower ratio is considered safe, as compared to 2 due to highly leverage of debts interpret as risky in case of unable to repay the interest or committed expenses.
- Rule of 72, the formula are:
- 72 / % return = no of years to double your capital
- 72 / % inflation rate = no of years the capital lost its value
- 72 / % credit card charged = no of years for the lender earned double from you
- 72 / year = interest to double*
This rule of 72 can only be use for a small number 5 to 9% while other number might show slightly different values. However, it give a quick idea how long it takes that affects its future value.
Remember, nominal rate and effective rate are two different rates. In order for you to plug that number into your FC-200V calculator, it must be a nominal rate and not an effective rate. Assuming the effective rate is 12% per annum. Go to > CNVR, n= 12 (; compounded 12 times in a year, because it is for a year) and i = 12%, > APR: Solve > 11.39% nominal rate. Thus, effective rate is taking compounds into the formula while nominal rate is simply a simple interest.
- Rule of 78, the number of 78 coming from 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12 = 78
Rule of 78 allow you to calculate the interest charges on loan. Rule of 78 detailed interest charges at its peak at the very beginning and settling it early means you paid more interest charges as greater portion of it is in the early of the commencement of the loan.
First, you have to find the Sum of Digits = (n x (n + 1)) / 2. Sum of Digits is the Rule of 78. For instance, 2 years is equivalent to 24 months. (24 x (24 + 1)) / 2 = 300. It means 1 + 2 + 3 + 4 + 5..... + 22 + 23 + 24 = 300.
In order to find the interest payable, you must calculate backward, and in this case is 24 months. The formula is Interest Payable = (24 + 23 + 22 + 21 / Sum of Digits) x Total Interest; to understand the first 4 months total interest paid.
Rebate, is used to calculate settling the loan before the maturity. The formula for rebate is
Rebate = remaining months + (remaining months + 1) / total months + (total months + 1) x total interest
Redemption sum to settle early = total outstanding after paid instalment - total rebate after paid instalment
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