That idea is cashflow. We’ll reach below its surface to discover a method that can transform your approach to every financial decision you’ll ever make.
What is it that lies below that surface area?
The answer is the four attributes of cashflow!
- Cash flows from you,
- cash flows to you,
- cash increases,
- and cash decreases.
Although it doesn’t seem like there is much here, we’ll use math to demonstrate how these attributes are used throughout Finance.
Let’s learn how to construct a fundamental cycle that drives stock prices, bond selections, business valuations, real estate transactions, investment performance, debt elimination, and insurance analysis.
The cycle is comprised of the following sequence: (1) cash flows towards an asset, (2) cash due increases, (3) cash flows from that asset, and (4) cash due decreases.
Here is an example:
- You lend a borrower $1,000,
- a 1% monthly interest rate is applied to and increases the balance due to $1,010,
- the borrower pays you monthly, $47.07,
- the balance due decreases by the portion of the $47.07 payment that isn’t the interest payment; for this first payment the interest payment is $10, but for each payment it decreases as the balance due decreases.
The above activity cycle continues for 24 months, after which the balance due has decreased to $0.00.
Sometimes the cash flow to the asset occurs over time. Sometimes the cash flow from the asset varies for some payments. Sometimes the balance due stays the same or increases, while skipping the decreases until later. Accounting for all the variations, allows us to account for the attributes of cashflow that are produced by every financial asset.
Let’s use math to show you how the above cycle can be used to determine when a debt is paid off, how much to borrow for a debt, how much are a debt’s payments, what the interest rate is for some debt.
What we need is a method that allows us to relate time, interest rate, loan amount, and payments.
How does interest rate, loan, and time relate to payment?
It depends on whether the interest is added to the balance or not. If interest is not added to the balance, then the loan applies simple interest. Otherwise, if it adds interest to the balance, then the loan applies compound interest.
Topics: Time Value of Money, Time Value of Money Applied to Debt, Time Value of Money Applied to Investments, Time Value of Money Applied to Financial Decisions, A Powerful Example to Help with Understanding Time Value of Money in Any Context.
If we compare the total payment over the two years, between simple interest and compound interest, then the difference is $144. That is the total payment of $12,544 is $144 more than the total payment of $12,400. It is unwise to conclude that compound interest is only slightly more than simple interest. As the duration of the loan increases and a single payment is made at the end of the loan, the payment for compound interest grows much larger than the payment for simple interest.
If the loan were for a 15 year duration, then the compound payment would be $54,735.66 and the payment for simple interest would be $28,000. That’s a big difference between the two ways to apply interest to a loan.