12 Most Important Finance Forumulas and Principles

12 Most Important Finance Forumulas and Principles

1.  Amortization

What it is: Amortization means making periodic payments over time to pay off debt.

How to use it: This equation calculates how much a monthly payment will be on a debt. Rearrange the equation algebraically to show what portion of each monthly payment will go towards interest and toward the principle.

Best for: Calculating the cost of long-term debt like mortgages, car loans, student loans, etc.

2.  Simple Interest

What it is: Simple interest is interest earned from principal.

How to use it: This calculation can be done quickly to provide an idea of how much interest will accrue over time. Just remember: This equation ignores the effects of compounding. You’ll get an error when you’re working with a larger principle and longer stretches of time.

Best for: A rough estimate on what you’ll earn in a savings account, or pay on a loan or a credit card.

3.  Compound Interest

What it is: The compound interest is the interest earned on the principal, and any interest accrued in the past.

How to use it: Use this formula instead of the simple interest equation to get a more precise number for how much interest will accrue.

Best for: Determining how much actual interest you will earn over time on an investment or pay on a debt.

4.  Cash Flow

What it is: Cash flow shows how much you earn in relation to how much you spend.

How to use it: See whether or not you’re living within your means. If the number is negative, you’re spending too much; if it’s positive, put the leftover money in savings.

Best for: Figuring out where to tighten your budget.

5.  Present Value of an Ordinary Annuity

What it is: The present value of an annuity equates a series of payments in the future to a lump sum today by using the time value of money (inflation)—a dollar today is worth more than a dollar tomorrow.

How to use it: Receiving $100 today is more valuable than having $10 handed to you every year for the next 10 years, because you could invest the $100 today then earn interest on it over the decade.

Best for: Deciding whether to take a pension or lottery prize as an annuity or a lump sum.

6.  Future Value of an Ordinary Annuity

What it is: The time value of money is also an important concept for the future value of an annuity, or the worth of your payments down the line.

How to use it: This equation answers the question: Should you take $10 payments each year for 10 years, or a lump sum of $120 in 10 years?

Best for: See what it costs to pay someone with regular payments over time or upfront. Examples: child support, insurance, etc.

7.  Compound Annual Growth Rate

What it is: As the economy moves up and down, so do investors’ returns. To determine your yearly growth rate over several years on an investment, use the compound annual growth rate, CAGR.

How to use it: Think of CAGR as the rate an investment would grow if the rate were constant. Investopedia has a good numerical example of this concept.

Bestfor: Determine the average rate of growth on a stock, bond, portfolio, real estate, or any type of investment over multiple years.

8.  Leverage Ratio

What it is: The leverage ratio compares debt to income. Total debts and liabilities are debts like student loans, mortgages, auto loans, and even the $5 you owe a friend.

How to use it: Aim for the lowest leverage ratio you can. Anything less than one is excellent, since you could pay off every debt with your income in one period.

Best for: Measuring your liquidity and determining whether you can afford to take out a loan.

9.  Rule Of 72

What it is: The rule of 72 is a quick approximation of how long it will take to double an investment.

How to use it: Take the rate of return on the investment and divide 72 by it to determine how many years it will take to double your money.

Best for: Choose multiple stocks, bonds, or savings accounts.

10.  Expected Return Of A Portfolio

What it is: The expected return of our portfolio shows what overall rate of return we’re likely to get on all our investments.

How to use it: Everyone wants great returns, but their tolerance for risk is different. This equation can help determine the perfect mix of risky and safe investments.

Best for: See if your portfolio has the right combination of stocks, bonds, CD’s, etc.

11.  Credit Card Equation

What it is: The ultimate equation for figuring out how long you’ll be paying off your credit card.

How to use it: Though it’s the most complex equation on this list, it’s still easy to do with a calculator. Use it to see whether or not you should pay more on your bill each month.

12.  Plus the Pareto Principle

The Pareto principle (also known as the 80/20 rule, the law of the vital few, or the principle of factor sparsity)[1] states that, for many events, roughly 80% of the effects come from 20% of the causes.[2] Management consultant Joseph M. Juran suggested the principle and named it after Italian economist Vilfredo Pareto, who noted the 80/20 connection while at the University of Lausanne in 1896, as published in his first paper, “Cours d’économie politique“. Essentially, Pareto showed that approximately 80% of the land in Italy was owned by 20% of the population; Pareto developed the principle by observing that about 20% of the peapods in his garden contained 80% of the peas.[3]

It is a common rule of thumb in business; e.g., “80% of your sales come from 20% of your clients.” Mathematically, the 80–20 rule is roughly followed by a power law distribution (also known as a Pareto distribution) for a particular set of parameters, and many natural phenomena have been shown empirically to exhibit such a distribution.[4]

The Pareto principle is only tangentially related to Pareto efficiency. Pareto developed both concepts in the context of the distribution of income and wealth among the population.