Basics To Financial Managment – Return On Investment
Due to poor financial management, many people find it hard to improve their chances of getting richer. This brings about the need to change many people’s mindset about finance, like how defects have to be fixed in leaking ships. Because of this,, the article was written to provide more knowledge on the field of managing finances well.
In the area of finance, people ought to know 1 single term very well and that is return on investment (ROI). This is because ROI is income that can be taxed the least but is most beneficial to you. For example, in earned income, you are always taxed at the higher tax brackets in income tax whenever you earn more.
However, if you invest in real estate, there is tax incentive called depreciation which looks like loss on financial statements but actually creates phantom deduction to shelter rental income. Also, investors can offset other income with passive loss from property up to $25,000 if you or your spouse qualifies as a real estate professional.
In addition, property may even be appreciating in value even though the tax man allows investor to claim that it is shrinking in value through depreciation deduction. Thus, for people who do not invest, you are actually getting punished by more taxes than those who invest and if you want to invest, you must know ROI at your fingertips.
To me, there are 2 types of ROI and they are internal rate of return and external rate of return. Basically, internal rate of return (IRR) means ROI without considering macroeconomic factors like taxes and inflation. In financial terms, it would mean a ROI that assumes all the income (passive/cash flow) you receive is immediately reinvested so that you would be getting a return on that money as well.
For example, rental income you receive from a property is immediately used to buy a stock that pays you dividend of 5% per year. Here, as macroeconomic factors like inflation and taxes are not considered, your internal rate of return will be 5% if you perform the above action.
However, while internal rate of return is important, external rate of return is actually a more reliable tool to gauge your total returns from an investment. Simply put, external rate of return (ERR) is ROI gained or lost because of indirect effect product has on taxes, insurance costs, inflation and opportunity costs.
Here, its importance lies in the very fact that it takes into consideration factors that are not immediately quantifiable or cannot be quantified. Thus, it is vital that we include both internal and external rate of return in any financial decision we make as it provides a more holistic approach to managing our finances by considering quantifiable and non-quantifiable factors. Here, always remember that IRR+ERR=ROI.
To make things clearer, here’s an example to illustrate how you can apply IRR and ERR even to your daily life. In many people, hand phones are a high expense and so to increase IRR, you sell it. However, remember that the hand phone also gives you convenience (not quantifiable) and because of your sale of it, ERR becomes negative and as a result, you gain a negative ROI instead of a positive one. Given this example, I hope readers will be able to practice financial prudence using ERR and IRR in your daily lives.
In conclusion, after covering the aspect of return on investment in financial management, I believe readers have gained a very clear understanding of how important it is to invest and also the right approaches to do so. Now, use what you learnt well and take action!