Fundamental Equation of Personal Finance

Profit in Business

Profit is the life-blood of every business. Even though making profit is not the sole purpose for every business, it is one of the main reasons that a business can prosper and last for generations. The art of making profit is governed by the following indisputable financial law:

Profit = Revenue - Expense

Normally, a CEO of a company is the person who is in charge of maximizing the profit either by increasing the revenue or reducing the expense or doing both at the time. An excellent CEO will generate large profit consistently year after year (Revenue > Expense) while a horrible CEO will incur debts (Revenue < Expense) that bankrupt the company.

In order to determine whether a company is competitive enough comparing to other companies, one uses the following equation which is derived from the above:

Profit Margin = \frac{Profit}{Revenue}\times 100\%

Given two companies A and B from the same industry, company A has a profit margin of 50% is more competitive than company B which has a profit margin of 25% in term of pricing power. An excellent CEO together with competence management teams are able to generate and maintain high profit margin for their business.

Profit in Personal Finance

Everything seems so natural when talking about profit in business term. When it comes to personal finance, one seldom gives much thought and even rare manages it as if it is his/her own business. In fact, personal finance can indeed be considered as your personal business with you becoming the CEO.

Here is the fundamental equation of personal finance:

Saving = Income - Expense

If you spend more than you earn, you are operating at a loss. Doing more work seems like getting no where and you are digging yourself a deeper hole if you are already in debt. If you spend less than you earn, you are generating profit and building wealth that allows you to pursue your goals.

Since the equation is so simple, it is so obvious that in order to increase your profitability, you can either spend less or earn more or do both at the same time.

The profit margin can be translate into the following in personal finance’s term:

Saving Rate = \frac{Saving}{Income}\times 100 \%

Having a high saving rate is an indication of you managing a highly successful personal business. With a saving rate of 50%, you can practically take a year off for every two years of work. You will have enough to survive for the whole year.

The key message is: the higher the saving rate, the earlier you could reach financial freedom.


How I do measure happiness in financial term? [To be continue…]


The power of profit margin