A diamond is forever

Question: There are many rules to follow when it comes to planning for the future. Some are quite complex and difficult to follow. What rules does your company offer to help the not-so- sophisticated people like me? Asked at “Ask a Friend, Ask Efren” free service at www.personalfinance.ph, SMS, Viber, Twitter, LinkedIn, WhatsApp, Instagram and Facebook.

Answer: Treat your household finances like a business.

To sustain a company’s future operations and growth, it will need to generate net income out of its shareholders’ capital or equity. And while this net income may be paid out to shareholders in the form of dividends, much of it will be plowed back into capital as retained earnings. Once inside retained earnings, the net income may be used to pare down debt or buy more earning assets.

In essence, what is important is for the company to raise net income out of equity. In finance this is called return on equity. The same is true for a household.

For a household, like in a company, operating costs need to be brought down to the bare minimum to leave a sizeable net income. In personal finance, there is such a thing called paying yourself first where savings are targeted first and deducted from gross income. What is left will be what the household can allocate for expenses. This means the household needs to have the propensity to save. The financial ratio that can measure the propensity to save is net income divided by revenues. For easier recall, let us call this “pala save.”

A household, like a company, can increase its earning potential by buying more earning assets.

And if the household has reached the limit of what its own capital can afford, it can rely on manageable debt. It is important that this debt is used mainly to buy earning assets that can more than offset the cost of the debt, and not be used for wanton spending. So, a household needs to have the propensity to borrow in the right manner. The financial ratio that can measure the propensity to borrow in the right manner is total assets divided by equity. For easier recall, let us call this “pala utang nang tama.”

At the risk of overemphasizing it, the proceeds of net income and contracted debt need to be invested in earning assets. For it is only with earning assets that a household can turbo-boost its revenues that can assure a better future for its members. Buying property, vehicles, jewelry, paintings that borders on vanity and greed will just lead to NPAs or nonperforming assets that will also bring about more (maintenance) expenses. So, the household needs to be investing in earning assets. The financial ratio that can measure the propensity to invest is revenues divided by total assets. For easier recall, let us call this “pala invest”.

It is by no coincidence that if you multiply the ratios of “pala save,” “pala utang nang tama” and “pala invest” to each other that the end result will be net income divided by equity or our earlier mentioned return on equity. And the higher the individual ratios are, the higher will be the return on equity.

One last thing though, to ensure that indeed the household will continue to flourish even if the breadwinners contract critical illness, become disabled or are taken early from this life, such breadwinners need to protect their downside by getting a stable institution to put up the money that they would have otherwise earned. This is where the breadwinners need to get insurance.

For easier recall, let us call this “pala seguro.”

To add an image to our ratios for even better recall, imagine the side view of a diamond that has three pointy ends and one flat top. On the left point will sit “pala save.” On the opposite point will sit “pala utang nang tama.” On the top flat end will sit “pala invest.” Finally, on the bottom point will sit “pala seguro.” This is what we call the Personal Finance Advisers (PFA) Diamond Model.

As they say, a diamond is forever.

Stay safe and healthy. INQ