When one attempts to forecast future numbers in terms of personal operating income or personal net income, one needs to know the growth rate in his personal finance. So, what are the variants of growth rates?
We need to project our personal finance numbers for various reasons. Maybe, you would want to know what your profits in future would be? Or, you might want to know your returns on an investment in a future period. You might want to know your asset turn in a future period of time, or your personal interest cover that requires your personal operating surplus in a future date, and so on.
Forecasting future income
One of the easier ways of doing this is just arriving at the average growth rate in the past few years. For instance, one might like to know the growth rate in his personal operating income if the growth rate in the post-tax operating income were 20%, 15%, 25%, 18% and 20% in the past five years. Then, we could say that his five-year simple average growth rate in operating income is 19.6%.
The other way of computing the growth rate is using the compounded growth rate method.
Fundamental growth rates
Historical growth rates may not be quite as useful in predicting the future. We may employ the fundamental growth rate in arriving at the forecasted income for an individual.
Growth rate for forecasting operating income: The growth rate in operating income can be computed by multiplying the return on invested capital (RoIC) by the personal re-investment rate. The RoIC is computed by dividing the after-tax operating income by the amount of invested capital. Invested capital is the sum of book value of equity and debt capital. Here, current liabilities are not considered in the computation of debt capital. Re-investment rate is computed by dividing the re-investment requirements by the after-tax operating income. Re-investment requirements are the sum of net investment in long-term assets and the positive change (i.e., increase) in working capital requirements.
Growth rate for forecasting net income: The growth rate in net income can be computed by multiplying the equity re-investment rate by the return on equity (RoE) of the individual. In fact, RoE is computed by dividing the after-tax net income of an individual by his net worth.
The equity re-investment rate is computed by dividing the equity re-investment requirements by the after-tax net income of the individual. Equity re-investment requirements are computed by subtracting the excess of the current year borrowing over the current year debt repayment from the sum of the net capital expenditure and positive change in the working capital of the year.
Let us assume that Amit Kumar has after-tax net income of R10 lakh, networth of R50 lakh, re-investment requirement of R3.25 lakh and R1.25 lakh as the excess of the borrowing over debt repayment in the latest financial year, which represents a normal year for him. Here the RoE is 20% and equity re-investment rate of 20%. Hence, the growth rate in future would be 4% i.e (0.2*0.2)*100.
Conclusion: We can also compute the growth rate of an individual by multiplying the RoE by the retention rate. This method is usually adopted for computing the growth rate in earnings per share of dividend paying companies. As an individual does not pay dividend to himself, we may not be able to use this method.
The growth rate arrived at by the above-discussed method should be equal to or less than the growth rate of the economy. Further, if we observe fluctuations in the personal income of an individual, we can take the average numbers, instead of single-year numbers in the calculations.
The writer teaches accounting & finance courses at IIM Ranchi