The extended money equation

Now that you have worked out your timeline and future values of all your goals, you have got a map of your future life both in terms of activities / events and also the corresponding financial needs. What is needed next is to understand the plan of how those financial needs are to be met. We will get to that shortly.

For now though, it is important to understand the money equation that links income, expenses and investment. Well, as readers of financial blogs and articles you must have been hammered relentlessly by the following equation:-

Income = Expenses + Investment  or  Investment = Income – Expenses or Expenses = Income – Investment

While there is nothing fundamentally wrong with the above equations, they unfortunately do not give us a complete understanding of the dynamics of personal finance that each one of us need to be clear about. If you look back at the post which talked about the dynamics of spending you will understand the need for something better. Over a period of time, I have zeroed in on the Extended money equation that is given below:-

IS = AI + PI – RME – DME – RAE – DAE – IRE

IS  : Investing surplus that is available with you, in order to invest for your identified goals.

AI  : Active income from your job, profession or business.

PI  : Passive income generated from your assets or other past investments.

RME : Regular Monthly Expenditure covering all mandatory expenses that occur every month.

DME : Discretionary Monthly Expenditure.

RAE : Same as RME but for expenditure happening annually

DAE : Same as DME but for expenditure happening annually

 IRE : Indulgence Related Expenditure.

Understanding the extended money equation in terms of what it means for you as a person, will change your financial life for the better. Note that while the equation is generic, what constitutes each category is very specific to you as an individual. To give a personal example, my DME has expenses related to buying books and eating out and my RAE has expenses related to travel. In fact travel is so important to me that I do not classify it as discretionary.

Once you understand the expenditure part, you will be in far greater control of your financial life. Let me give the analogy of a storage tank here – water is coming in through some pipes and is taken out through others. Now in the above equation, AI and PI are your incoming pipes. RME, DME, RAE, DAE and IRE are all outgoing pipes. You can have some of the pipes closed but not all.

 At the beginning of your career you will have only AI and no PI ( closed pipe ) and when you are retired the situation reverses. RME will never be a closed pipe and it is not easy to control the outflow also, similar situation for RAE. You can control the flow of the others or even stop them as needed. IS is what you are left with for investing.

I will be interested in knowing whether you have understood the extended money equation and can relate it to your own situation. As this post has already got quite long, I will deal with the practical usage of the extended money equation in a future post.

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13 thoughts on “The extended money equation

  1. Hi,

    Nice post. Great that you were able to do this so many years ago.

    Sometimes we tend to under estimate importance of financial planning thinking of future salary as increments adjusted, without adjusting expenses for inflation.

    1.63 crores as course fee might seem obscene today (excl. Mbbs/md), but might well be the norm tomorrow.

    Hopefully you will elaborate on how to set up savings /investments to match each financial goal.

    Regards

    Like

    • Hi George,

      Yes, a lot of my goals were framed correctly, which gave me a solid grounding. Can’t say the same about all my investments though !! 1.63 crores will hopefully be a much higher figure than the actual cost, but you never know how situations change.

      When I studied in IIM Calcutta, my entire expenses for 2 years was less than 1 lac.Today it will be about 24 lacs for my daughter if she makes it. This is partly inflation but also the fact that IIM education is not subsidized by the government.

      Yes, I will cover the plan completely – keep reading.

      Regards

      Like

  2. I can correlate fully with RME/DME and RAE/DAE. 🙂 The problem we face while managing money, is that we seldom segregate the fund available and tend to keep numbers in mind (atleast thats what I am doing). I have written down my goals and prioritized it but if you ask if I am sticking my money management according to that, I am afraid that answer will be no. May be the prioritization is wrong thats why it is not possible to follow or the temptation to spend is too high?
    Financial independence (I have specific no. in mind) is my #1 goal / tops in priority list and i feel guilty of spending in DAE/DME.

    Like

    • Well, the situation may have several causes. It may be you are spending more than you can afford, but it can also be that you are not investing in the right vehicles for the kind of growth your plan needs.

      If you want to share the timeline of goals here ( financial values are not important ) I may be able to say something more specific. In any case, keep reading the next few posts on how to practically use the Extended money equation.

      Like

      • Here you go:

        Goal # 1 Financial Freedom (Money to support “needs”) : Timeline: Dec. 2016.

        Goal # 2 Purchase House : Timeline: Dec. 2017

        Goal # 3 Yearly Holiday/Exp fund: Dec. 2018

        Goal # 4 Purchase a car (Sedan): Dec. 2018

        Goal # 5 Other Discretionary Purchase fund: Dec. 2019

        If I continue with current job/work, I am on track with Goal # 1 and can certainly reach all the goals as per timeline. But I have the entrepreneurial bug too and looking to take chances. Most probably after Dec. 2016. Most of my DAE/DME can be justified for personal growth / Business exp. But I feel that I am not sticking to the plan which I have written down. The discretionary purchase is lowest priority item in my list but at the same time, I just can’t delay the spending by seeing the value addition or future personal growth.

        Like

      • It is important to set priority for the goals. In your case, all your goals are in the next few years and meeting them will require use of existing assets.
        In terms of how to plan for future goals, pls read the posts on financial planning that I am writing currently.

        Like

  3. Hello sir, this is one financial equational post which I fully understood.otherwise complex term and data puzzles common person.looking forward to read more posts on this topic..

    Like

  4. Dear Raj,

    I believe AI, PI, RME and DME should be annualised before calculating IS isn’t it?

    Both RAE and DAE are annualised components.

    Great article!

    Thanks
    Sunil

    Like

  5. Though I don’t agree with you on many points, but this article really nailed it. I am following a similar plan for the last few months (since i started working).

    Like

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