A Layman’s Introduction to…. Cash Flow

A Series of Articles Inspecting General Financial Terminology

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This is the next in a series of posts looking at some general, basic financial terminology from a non-expert perspective. The topic covered is Cash Flow.

What Is Cash Flow?

Definition

Your cash flow is the amount of money moving in and out of your personal finance statement over a period of time. By increasing your cash flow you are ‘building financial muscle’.

If you read last weeks post on liquidity, you will understand the importance of having enough cash on hand to meet your commitments. By assessing and projecting your cash flow you will understand how your liquidity changes over time. By tracking your cash flow you will also gain an understanding of the true power of your money.

How Do I Work out My Own Cash Flow?

If you wanted to you could track your cash flow on a day-to-day basis but as long as you maintain sufficient liquidity this should not be necessary. I track my cash flow on a month-to-month basis.

Most people track their own finances on a spreadsheet. As such, you need to review and track the following:

  • Current Assets: how much cash you will have available during the chosen timeframe
    • This includes income from work ie. salary, plus any other income during the time period (such as dividend payments from an investment asset you own)
  • Current Liabilities: the sum total of all your bills and payments due in the timeframe
    • This includes all your bills (mortgage, gas, phone etc.) that need to be paid during the month, plus any other liabilities that fall due

Now you need to repeat the exercise for the subsequent timeframes, ie. the next month, and the month after that, and so on. Since our income and expenditure varies from month to month our cashflow will also change.

Example

John has a full-time IT job but also makes additional income from quarterly dividends. He earns from periodic consulting work in the springtime. His home & living costs are generally fixed but when he is not consulting he tends to spend more money on entertainment as he has more free time. He also has some savings invested in the stock market.

John has budgeted his next 6 months and finds that his total income will be $19,072 and his total expenditure will be $18,911. This is good, right? He will spend less than he earns, however these numbers do not tell the whole story.

John has also performed a cash flow analysis and presents the following:

Cash Flow

The two lines at the bottom of John’s analysis are most pertinent:

  • John’s net cash flow for the months of January 2017 and February 2017 are negative (highlighted in red). This means that John has more expenditure than income during that time period.
  • His ongoing cash balance projection shows that John will have insufficient liquidity to meet his liabilities in January 2017.

The point of this exercise is to show that although John will earn enough income during the 6 month period, he will not have enough cash available at the times he needs it! What will he do? In that situation he would have to borrow enough money from a friend to pay his bills or pay late (risking additional fines). Or he would have to find the money through some other method such as selling off his investments. In graph form:

Cash Flow Chart
John runs out of money in January and remains underwater until May. During this time he will have to borrow or sell assets to cover his liabilities

Why Should I Care About Cash Flow?

As the example has shown, it is not enough to simply spend less than you earn. You must be aware of when and how much money you will earn and spend over time.

It is no use stretching your finances to buy that bigger house you saw if the mortgage payment will cripple you in 3 months time. By tracking your cash flow you ensure that your financial foundation is built on solid ground. You can plan ahead to ensure that you will always have enough cash available when you need it.

What Does Your Cash Flow Look Like at droppedcoin?

I have plotted below the first 6 months of the year for my cash flow.

My Cash Flow

Two things are evident this chart:

  • I started the year with very good liquidity
  • I have been on a work sabbatical since the start of the year thus have not been earning money, yet of course have still been spending

As I try to ensure I have at least 1 years liquidity ratio available at all times, my cash flow usually remains comfortable!

6 COMMENTS

  1. Great post, I loved all the accounting terminology 🙂

    Personally I think it is interesting to look at your expenses on a daily basis sometimes. Like add up your cost of rent, food, gas, etc. (even though you might not be paying cash up front). It’s a fun exercise and really gets you thinking about what to spend money on.

    • Hi Andrew,

      Thanks! I believe we should run our personal finances as if it were a business. I think it would help us make better decisions.

      I used to love to review my expenses on a daily basis but these days it seems to be too much effort for too little reward – added to which my constant travelling means my spending is tremendously varied so I now find it hard to make much sense of my numbers!

      Cheers,

      Paulie

  2. You explain these terms well here Paulie! I must say that cash flow certainly is king and I like these introductory guides.. Possibly an E-Book in the making? 🙂

    • Thanks Jef. I originally intended these posts as kind of a ‘filler’, but they seem to be attracting the most attention! I guess the bite-size approach is more easily accessible. I could definitely see these forming an ebook in future!

      Isn’t it amazing though, how even the ‘simplest’ posts we concoct turn out to have so many possibilities and take so much time?! I find myself getting lost writing a post very often, and sometimes I cut myself off way before I feel a post is ‘ready’!

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