Our last post left off by describing the limitations of net worth and why another measure is also needed. This week we’ll discuss the concept of cash flow and how it provides a second important perspective on your finances.
Cash flows: How Your Finances Feel
Let’s say you need $1,000,000 to retire. If I told you that based on where you are today, you could achieve that number within 10 years, that might sound promising. What you wouldn’t know is what it takes. Maybe saving that kind of money means a decade of living in a studio apartment with roommates, eating nothing but rice and beans, and walking everywhere you go. Maybe it only means cutting your spending by 3% and investing your existing funds in a more aggressive portfolio. In either case, your net worth would hit the $1,000,000 after 10 years but clearly these two paths would feel very different. Cash flow is the metric that gives you a sense of how your finances might feel.
To calculate your net cash flows, you add up all your sources of income and subtract off all your expenses. If your net cash flows are positive, you’re saving money each month, while if they’re negative you’re drawing down your savings. It can be particularly insightful to look at each income or expense item individually, which is one way of thinking about budgeting.
To give you a more concrete sense of why you’d want to look at cash flows and how they can tell you about what your finances will feel like, let’s consider a simple example. Suppose that after all taxes and deductions, I have $4,000 of income deposited in my checking account each month. On average, I spend $3,000 of this on rent, transportation, and similar necessary expenses and have $1,000 to do what I please with. I’m trying to decide if I’d rather continue making the minimum payments of $300 a month on my student loans or increase the payment to $800 and finish paying the loan in 3 months. Projecting out my cash flows over a 4 month period can be helpful in understanding these two options.
In the first scenario, I continue to make the minimum payment of $300, meaning I have $700 each month left over for things like entertainment, travel, etc. Because I won’t pay off the loan within the 4 month horizon, when I project out my cash flows they look the same each month and if I feel good about having $700 of discretionary income, I’m pretty comfortable at every time point.
In the second scenario, I decide to put $800 each month toward my loan to pay it off early. In this case, I’ll only have $200 left over for the first 3 months, which may mean things are pretty tight and I really have to cut back on discretionary spending. However, once I reach month 4 my loan is paid off, I don’t have any minimum payments, and I can spend the full $1,000 as I wish. This change shows up clearly in the projection of my cash flows as a jump in my net cash flow in month 4 and corresponds to the relative financial freedom I’d feel from paying off the loan.
As this example illustrates, looking at my cash flows in this way gives me a sense of what my budget will feel like in different scenarios. It makes it easy for me to ask what happens if I allocate my spending differently and how it might look after some period of time. Findi incorporates the cash flow view of personal finance to give you this sense of how making financial decisions could feel.
However, like with net worth there are limitations to the cash flow view. First, it doesn’t give me the big picture. Cash flows tell me where my money is going each month, but not if I’m on track to reach my goals (conveniently, this is the gap net worth fills). Second, it can be hard to assess if a cash flow is good or bad out of context. If my net cash flow is negative, that could indicate that I’m chronically overspending and will eventually run out of money, or it could indicate that I’ve made a temporary choice to draw down savings to pay down a high interest credit card for example. Lastly, looking at cash flows in this way misses out on transfers all together. If I decide to move extra money sitting in my checking account into a Roth IRA, that’s probably a good decision as that same money will grow at a higher rate. However, because the transfers are neither income nor expenses, they won’t show up in your cash flows.
Using Net Worth and Cash Flows Together
Having looked at net worth and cash flows individually, we can now connect them. Simply stated, cash flows are the change in net worth. Or from another perspective, if we add up all the cash flows over time, we get net worth (we’d really need to start from birth for this to be completely true, but you get the idea). The two concepts are complementary and provide different views of the world. For calculus aficionados, we can think of cash flows as the first derivative of net worth.
So how do we use the concepts in personal finance? Start by looking at your net worth. As explained above, this gives you a quick snapshot of your finances. Next, consider the financial choices you could make and forecast the impact of each choice on your net worth. Before deciding, take a look at the cash flow view as well to get a sense of if you’re willing to live with the changes it would mean to your month-to-month budgeting. Once you make a choice, update your forecasts and repeat the process.
While conceptually straightforward, getting the math right can be time consuming and surprisingly challenging. Some of the forecasting could be done in a spreadsheet, but creating and maintaining spreadsheets for each decision is impractical. Findi is designed to take care of the calculation and forecasting process for you, so you can focus on making changes that lead to financial independence. We find the actions needed to maximize your net worth and show you the cash flows so you can make the right choices.
Have questions, comments, or suggestions for future posts? Leave me a note below and I’ll do my best to reply.