Mastering Cash Flow
I love camping and backpacking. It's the general thrill from exploring new places that makes sleeping outside fun. I hope to raise my kids with the same passion, but until then we’ll make do with backyard fires in our Solo Stove.
One of the lessons you learn when camping on cold nights is how to stay warm. When it comes to a fire there are two options. Either make a huge fire and stay warm by collecting more wood or make a small fire and stay warm by nurturing it with a few sticks at a time. This lesson applies to managing cash flow too. What follows is some thoughts on having a spending plan. With it you can either live above your means and work hard and try to earn more and more cash to buy more and more stuff or you can live below your means and build a nest egg which will help you gain financial independence.
Mastering Cash Flow
And creating a less risky lifestyle
The basis for nearly all good financial planning is cash flow management. Knowing where your money is coming from and where it’s going is a critical element to the planning process for everyone, no matter their stage in life.
Unfortunately, it’s one of the more tedious planning items and is associated with a task that no one likes: budgeting.
At the end of the day, cash flow is king. Until you get control of your expenses and put in place a spending and saving plan in place, it’s hard to accumulate wealth.
Having a spending plan
Budgeting has a marketing problem. No one likes it. Human psychology doesn’t handle making little sacrifices everyday well. So, let’s call it a spending plan instead. Afterall, having a spending plan is like saying yes to expenses, where budgeting feels like you’re saying no to everything.
Having a spending plan is a lot like dieting, and no one likes dieting either. It’s not fun to say no to dessert or extra cheese on your pizza. But the point of dieting is all about calorie management. Eat more than you burn and you’ll gain weight. It’s the same thing with a spending plan. Spend more than you make and your cash stash never grows.
I have a secret. I track every expense down to the penny every week, month, and year. I’ve been doing that since 2011. For instance, I know with certainty that I spent $9,953.17 on groceries in 2016. Being aware of the expenses in my life and having a spending plan helps me control my cash.
A spending plan, therefore, helps us stay aware of where our money is going. You don’t need to track the cost of groceries to the penny, but you should know the big picture on how you spend. Ultimately, a spending plan can help you craft a less risky lifestyle.
Paying yourself first
What you don’t spend, you save. Spending is easy, saving is hard. An easy way to take away the difficulty of saving is to pay yourself first. Savings is best done when it’s automated and you take yourself out of the picture.
The best place to start is by automating contributions into your workplace retirement plan. Start by saving up to the employer match, and set it to increase by 1% every year. A match is the amount your employer contributes on your behalf, up to a maximum. Not saving in a 401(k) and not taking the match is leaving money on the table.
When you automate this process, you pay yourself first. This makes it easier to stick to a spending plan because the savings is already out of the way. And with a 401(k) it’s out of sight, out of mind. The temptation to not save is avoided. As Warren Buffett says, “Do not save what is left after spending, but spend what is left after saving.”
It doesn’t take long to hardly notice the cash deposited in our retirement plans. We adjust. Automatically saving into a retirement plan helps us reduce risk in our life by preserving funds for the future and getting us used to living on less.
When we reduce our risk, we make progress, and when we make progress, we get closer to our goals.
Reducing lifestyle risk
Like a well-run business, you want more cash not less. Healthy companies create positive cash flows. Unhealthy ones don’t. We can translate this to our personal financial statements too. Everyone should have a personal balance sheet and cash flow statement. This way you can track your progress to make sure your finances are healthy and you’re in control.
The thing about risk is that we know it’s out there, we just have no idea when it will strike. The best way to cover short-term financial shocks is by maintaining cash reserves, or an emergency fund. This reserve fund is not for a new TV (Darn it!). It is a permanent cash buffer in case you lose your income. Cash reserves are best in a bank savings account.
How much you should reserve is based on a) how likely it is you could lose your job and b) how conservative you want to be. A minimum cash reserve should be about 3 months living expenses, and the maximum is around 12 months of living expenses. Your living expenses should be easily found in your spending plan.
We borrow when we buy things we cannot afford. Debt helps us bridge the gap. Without debt most of us wouldn’t be able to buy a house or buy a car. Increasing debt could indicate you’re living above your means.
However, there are some rules to follow. For instance, debt ratios can help us determine how much house we can afford. Don’t worry about what the bank tells you, run your own numbers! So, calculate your “Housing Ratio.” Add up the cost of your mortgage principal and interest, your real estate taxes, and your insurance. Divide that sum into your gross income. Target a rate of 28% or less.
The less the costs of housing and debt make up your gross pay, the less risky your lifestyle. Eliminating debt means eliminating what you owe other people. And the less you owe, the more in control of your finances you are.
Over time, as long as you’re sticking to a spending plan and a pay-yourself-first savings plan, your net worth should grow.
For many it’s known as retirement, but I like to call it the point of financial independence. This is the point when you don’t have to do anything for money you don’t want.
Try to set savings rates, which is the amount saved divided by income, between 10-20%. Those who save more and invest wisely will likely reach financial independence quicker.
With diligent savings your investment assets will eventually eclipse your income. A rule of thumb is that when your investment are about 20 to 25 times your gross, you’ve won the game. You should now be financially secure.
Earning the right to invest
A spending plan, automated savings, and reducing risks are critical to helping you be in control of your cash. Once you’ve got a handle on your expenses and your lifestyle, you can begin to save and invest.
Before you earn the right to invest in a brokerage account, first take advantage of your workplace retirement plan and maximize benefits. Then fill up your cash reserves. Then make progress on paying down your debt. Once you’ve accomplished all this, now you can feel comfortable setting up an investment account.
Like a healthy, growing business, you put your excess cash to good use by investing for the future.
I’ve laid out quite the prescription. So how do you know if you’re on track?
The process starts with your most recent tax returns. W2’s and 1040’s immediately tells us how much is coming in and how much is being eaten up by taxes. Next, we review savings. How much is going to retirement plans, how much is going to cash reserves, and how much is going to investment accounts. Then we review loan documents to understand the costs of debt, notably housing and auto costs. Last, we review insurance policies to understand the costs of how you’re managing risks. The remainder is a rough approximation of your lifestyle costs.
Use this newfound data to build personal financial statements. There should be a statement of cash flows, and a personal balance sheet. You can refresh these documents annually to track your progress. You want to see improving ratios for debt to assets, net worth to assets, and investments to gross pay.
If you don’t plan for where you’re going, you’ll end up someplace else. The first step is mastering cash flow. It’s simple but not always easy. You don’t have to do it alone; we have a process that works. Get started today.
Adam K. Wright, CFA, CFP®
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