Question: What is a quick way to know if I am on the right track when it comes to managing my finances? —asked at “Ask a friend, ask Efren” free service available at www.personalfinance.ph and Facebook.
Answer: You need to get A.I.D. where “A” is for assets, “I” is for income and “D” is for debt.
All through life, we accumulate assets not only to enjoy today through non-earning assets but also to secure a better future through earning assets. There are only two sources for funding assets: They are through other people’s money or debt and through our own money or equity.
Sacrificing current enjoyment will afford a brighter future. But the sacrifices must translate to more allocation to earning assets. The simple measure to know whether earning assets are paying off is if our asset turnover (i.e. gross income divided by total assets) is continually improving until it reaches the optimum sustainable level.
As mentioned, part of the funding for acquiring (earning) assets is from our income that we reinvest. This reinvested income is what is left after paying for necessary household operating and discretionary expenses, and is also an addition to the equity in our household. The larger the net income we reinvest, the more earning assets can be acquired. We are saving more if we have a high net income margin, which is measured by net income divided by gross income.
The other source of funding for acquiring (earning) assets is debt. If debt is used for current consumption or buying non-earning assets, it will have little or no multiplier effect to our own equity in acquiring (earning) assets. Conversely, the more debt is used to fund asset acquisitions, the better will be our future. The multiplier effect of debt to equity is arrived at by simply dividing total assets by equity.
Let’s put a pin on the previous discussions first. When we invest our money, what we normally want is a return on our investment. And since our investment represents our equity in the venture, we can also say we want a return on our equity, which is simply net income over equity.
Return on equity or RoE will vary from household to household. That is why it is important to just track our own household RoE over time.
To arrive at our RoE, we simply divide our net income over our equity. But that does not tell us much. We can instead just multiply our asset turnover to our net income margin to our equity multiplier. Doing so would make gross income and total assets cancel out in the formulas, leaving just net income over equity.
This time around, however, if we track the components of RoE over time, we will know if the changes are attributable to the ability of our assets to produce additional gross income, our savings rate level and/or our use of debt to buy additional assets.
So, for a dashboard to monitor our finances, we just need to track our asset turnover, net income margin and equity multiplier, all of which are brought to us courtesy of A.I.D.—assets, income and debt.