4 Financial Concepts for the Financial Minded
This article will lay out 7 financial concepts that every financial minded individual needs to know...and not only know of...or about, but understand. When these financial concepts are put into play in our everyday financial lives, they help us make better financial decisions.
Compounding Interest
The power of compounding interest had to be added did it not? After all, Einstein himself called compounding interest the eighth wonder of the world. To quote Einstein directly, he stated:
"Compound interest is the eighth wonder of the world. He who understands it, earns it...he who doesn't...pays it."
The way that compounding interest works is that over time, interest is earned on money and if the money earned gets reinvested at the same interest rate, then a person begins to earn interest on the interest they earned. Thus, it "compounds" on top of itself.
Let's look at an example. Let's say that a person has 1 dollar and that dollar is earning 10 percent interest on a per annual basis. At the end of year 1, a person in this scenario would have earned 10 cents on their dollar invested...or 10 perecent. Now, instead of taking the 10 cents they earned and spending it, they reinvest it back into the same account earning 10 percent. Now the person has 1 dollar and 10 cents invested and at the end of year 2, the person in this scenario will have earned 11 cents on their investment and now have 1 dollar and 21 cents in total. So continuing forward, this person earns a little bit more each year from the money they originally invested.
This scenario can also work against a person if they are a debtor...as the Einstein quote indicates. The longer a person remains in debt, the more interest they will end up paying someone else.
Time Value of Money
This financial concept goes hand in hand with the previous financial concept...and its true this financial concept goes hand in hand with a lot of different financial concepts.
The time value of money is a financial concept that states that money tomorrow is worth less than money is worth today. Let's look at an example. Let's say that a person has 1 dollar today, just as in the illustration with compounding interest, the interest rate is 10 percent and in 1 year we have 1 dollar and 10 cents or $1.10. That means that $1.10 is the future value in year 1 of 1 dollar earning 10 percent. This equation can be demonstrated as follows:
Future Value = Present Value(1 + r)n
r = Interest Rate and n = Number of years (or periods)
That is how the future value of money works. Now le'ts look at an example of the present value of money. The present value calculation is used when a person is to receive money at some point in the future and using a given interest rate, would like to know that money's worth or value in today's dollars. The (future) money must be discounted back to the present value using the interest rate given or chosen. Let's say for example that a person is promised to receive $500 in 5 years and if they had the money today, would earn 10 percent interest per year. In order to solve this problem, the following formula would be used.
Present Value = Future Value / (1 + r)n
r = Interest rate and n = Number of years (or periods)
By using this formula, it is determined that receiving $500, 5 years from now, is worth about $310 today if I could earn 10% interest. This assumes the interest would be compounded annually. By understanding time value of money, a person can gain a clearer picture of how compounding interest works as well.
Internal Rate of Return
Internal rate of return is a very important financial concept to understand. Internal rate of return or IRR for short is a calculation that is made in order to determine any investments rate of return adjusted for the time value of money. Often times, people speak generally about an investments rate of return but they don't actually know what they are speaking about specifically. And between investments, there are different definitions and different calculations for rate of return. The internal rate of return is the gold standard of rate of return calculations...and this is because it allows investments accross industries, and investment type to be compared by a standard metric.
Internal rate of return can be considered "standardized" because IRR focuses on one thing across all investments and across all industries, and that's cash flow. IRR makes its calculation solely based on an investments net cash flow to the investor(s). Net cash flow is simply just cash flow net of all expenses. Before getting into the details of how this is calculated, a person should understand that the internal rate of return cannot be calculated without using computers. Don't try calculating this without technology of some kind whether that is a financial calculator, or one of our financial calculators online.
To explain the IRR calculation, first a person needs to understand Net Present Value or NPV. NPV is where net cash flows are discounted back to the present value. This is similar to the present value calculation above, however it must happen for multiple cash flows that happen in different years in the future.
The reason NPV is important, is that it is used to calculate IRR. The internal rate of return is the rate that when used to calculate Net Present Value...causes NPV to equal 0. The formula can be seen below....and like we said, don't try calculating this without a calculator.
Photo Credit: Wikipedia
Net Worth
An individual's net worth is the sum of all of their assets minus their liabilities. Liabilities is just another word for debt. An individual's net worth does not speak to their personal significance at all but rather only to the amount of money or assets that individual has above and beyond any liabilities or debt.
In order to calculate a net worth, first a person must add together all of their assets. Assets may include items such as home value, value of all automobiles, individual retirement accounts or IRAs, individual or joint brokerage accounts, cash value life insurance, bank account checking or savings, any precious metals one might own, other real estate investments, and any other item that has value that could be considered an asset.
Next, a person needs to add up any and all liabilities or debt.