There are four aspects of personal finance that we deal with every month, unlike taxes and insurance which are typically annual affairs.
Income
Debt
Expense
Asset
Thus the I, D, E, A is what one deals with every month – month after month in that same order.
Typically a household finance (or monthly cash flow) goes like this:
Income (I) -> Pay Debt (D) -> Pay Bills (E) -> If left over, invest in assets (A)
The problem is that the IDEA is wrong. It will never make one financially independent as the Asset part is only an afterthought, and mostly never happens.
This requires a correction in perspective and is much touted by financial advisors as Pay Yourself First, where A should come before D and E.
So the IDEAL sequence is I,A,D,E,L.
Income (I) -> Pay for Assets (A) -> Pay Debt (D) -> Pay Bills (E) -> If Left over (L), have fun.
The last part if consistently found to generate surplus, can also be adjusted for subsequent months to increase the “Pay for Assets (A)”.
How does one do this course correction? Here is one simple technique.
You know how much Income comes in.
Decide a percentage (start a bit aggressive, like 20%) to set aside for A.
But do not invest yet, just set it aside to another savings account.
Pay your debts (D).
Pay your bills and monthly expenses (E).
If shortfall, pull a bit from the A saved aside.
If not, good news. Invest the 20% into assets (A) and enjoy any surplus (L).
This habit if done over 3-6 months, will build the automatic flow of savings and investment.
The sequence described above has the following automatic advantages.
It starts with an aggressive savings goal of 20%.
As one sees the expenses budget drying up towards end of the month, it encourages one to cut unnecessary spending.
The savings is still saved aside till the end of the month, so can be pulled in if needed.
Pulling in the savings every month however has a mental resistance, hence should be difficult to do month after month.
To make it more difficult, put the A into another bank so that the transfer will take some time and effort to execute.
As one adjusts to a comfortable level of savings (A) percentage, it brings in awareness of how the budget and cash flow works.
The IDEA is not so bad after all, you just need to fit it in the right sequence to work.
A company which is listed in the stock market has to publish 3 essential financial statements.
The balance sheet
The profit and loss statement
The cash flow statement
Briefly, the balance sheet shows the health of the company at the reported time, profit and loss statement shows how much profit the company is making after all expenses and taxes, and the cash flow shows how the company is generating the cash from its operations as well as investments.
Free Cash Flow (FCF) is an important metric that is used by investors to evaluate the real worth of a company.
In personal finance, while balance sheet (Your net worth) and profit and loss (how much you are making and spending) are important, managing the cash flow is key to achieve your financial goals.
In this blog, we will talk about how to manage your cash flow – no matter whether you earn a lot or earn an average paycheck.
Most people do not manage their cash flow, forget about doing a budget or any other conscious form of tracking.
At the end of the month or year, we wonder where all the money earned went.
Conventional ways of managing cash flow
There are several techniques Personal Finance experts have championed time and again.
Do a budget, track every dollar.
Create an envelop for groceries, utilities, fun etc.
Use separate accounts.
New automated solutions like Stash, Digit etc.
All of these are good methods, but the problem is sticking to the discipline of maintaining it day after day, month after month.
Isn’t that boring and worrying at the same time? Few issues with these approaches are:
Writing down expenses every day
Stuffing that envelop and counting the money every time before spending
Keeping track of multiple accounts
Not knowing how much the AI driven savings app is going to deduct next month
So is there a simpler and better way?
Just like most posts in this blog, I seek simplicity and automation.
The simpler way of managing your cash flow
There are 4 goals to managing the cash flow every month.
Invest for the future
Save for the short term
Pay your bills
Spend the rest
In fact, any wind-fall is also a one time cash flow, and can be fit into the same framework. Lets say you got a bonus of $1000, for example, the Govt is sending a check to all Americans. And if you want to keep it simple, allocate 25% to all the 4 goals.
Invest $250 in your long term (retirement, child education) plans. The market is down and you can invest $250 in a mutual fund or an ETF.
Save $250 for any short term goals that you have. It could be added to your monthly savings goals, towards anything like vacation, buying that new phone, or simply emergency fund.
If you have consumer debt, why not allocate some to pay it off? Use $250 to pay off the highest interest or smallest balance credit card.
Now you have $250 to splurge on. Buy that favorite book, order the special meal or decorate your home.
But how do we automate and manage the cash flow every month?
Invest – Direct deposit investments. In fact most employers have systems to auto-deposit 401-k investments or direct deposit to your chosen brokerage firm.
Save – Auto transfer to a savings account from your checking account.
Pay Bills – Setup auto-pay with your credit card or debit card. Set the bill payments mostly towards beginning of the month.
Spend – Use your debit card to spend – it will tell you when the money runs out.
Once setup, the only stress you have is the last bullet, where you have to make your spending within the limits, or rather the residue after all obligations are set aside or paid off.
How it can snowball into Financial Freedom
As you get consistent with stashing money away for investing and savings, those may generate additional cash flow or assets which will come back to bolster the spending budget.
Thus cash flow is a virtuous cycle once set up the correct way. Lets take some initials and approach this from a math perspective.
J – Job Income
R – Retirement
I – Investment
S – Savings
B – Bills
E – Expense
P – Portfolio Income
J + P = R + I + S + B + E
Ican produce Pin terms of interest, dividend or rental income.
In the wealth accumulation years, the goal should be to increase J, so that Ican be increased, which when invested can increase P. Pis added to J and a part reinvested, saved or used.
As you reinvest P, it will generate more P till at a point, J becomes less and less important.
This cash flow situation is called Financial Freedom.
Conclusion
We just presented a simple and fully automated cash flow management system for personal finances. It does not take much discipline and will power to stick to it, once correctly setup.
What is your net worth? Let me see, probably close to a million. So what? Are you financially independent? No. Why? ’cause I don’t have enough cash flow to replace my W2 income. Ok then, net worth is a worthless metric. But it projects my comfort into the future.
And so it goes on and on…
Does it sound familiar? There are two schools of thought. One says be conservative, save, invest for growth, have little to no debt and build your net worth slowly. The other school scoffs at this conservative approach, and instead propounds building wealth and cash flow through acquiring assets, leverage and working out deals.
None of them are wrong. However what is right for you (and me) is important. For that, it is extremely important to understand the benefits and risks attached with each approach.
In more practical sense, you will do both in the right proportions that you are comfortable with.
The Net worth approach:
Here your main cash flow is your W2 income. Your ability to live below your means gives you the leverage to save and invest the rest.
As you invest your money into stock mutual funds, CD, money market, bonds and a house of your own to live in, you are increasing your net worth slowly. This is how most people start and someone starting off should. The difference between income and expenses, is the main contributor to your net worth. Additional is the appreciation and growth that your investments achieve. You also pay down mortgage of your house which builds equity, adding to your net worth.
In my opinion, this is a perfect approach to build wealth as long as you enjoy what you do in your W2 job and have a good work-life balance.
This is also the simplest since there is no extra debt burden (except probably your house, which you can pay down if you want). Your investments are also passive and takes hardly any time from your schedule, except occasional re-balancing and tracking.
With a spreadsheet like Excel, you can easily calculate your projected net worth in “t” years in the future, assuming a “r” rate of interest (or growth).
However this approach takes a lot of time and patience, disciplined living on a budget and regular investments. You will not have something to brag about in a few years, but you will sleep in peace as you have liquidity, less or no debt and enjoy your work.
The risk of this approach is if you retire early and do not have enough corpus to live off for the rest of your retired life.
The Cash Flow approach:
The cash flow approach on the other hand, only focuses on generating cash flow. It means you have enough assets or mechanism (businesses, activities) which generate cash month after month, in a predicable fashion.
This can be achieved with several avenues for example:
Rental property investing
Commercial property
Dividend paying stocks
Passive income from books, royalty of other IP, YouTube videos etc.
There are many resources on Internet to give a list of passive income ideas.
However in the cash flow investing approach, I wish to draw attention to the big ones like Rental Property Investing and Dividend Stocks.
These are two ways which makes a very predictable cash flow stream if done right.
However to get this predictable cash flow, one has to do the investment right. For example, real estate has many hidden costs and running expenses, which if not taken into account will quickly convert an on-paper cash flow asset into a black hole for your money.
Similarly dividend stock investing, if not researched correctly can cause the principal investment value to go down. Same for income producing corporate bonds, where the ability of the company to make the regular payouts needs to be researched.
Last but not the least, income producing real estate is typically obtained through leverage, which means steadily increasing debt.
For example, if you want to generate $5000/mo in cash flow from real estate, you need to buy as many houses that will in total produce that much positive cash flow. Lets say each house produces $200/mo in positive cash flow after mortgage, taxes, insurance and expenses. Now you will need to manage at least 25 such properties to generate the requisite cash flow. Self managing 25+ properties is more than a full time job, and if you hire a property manager you will have to part with the cash flow (fees), and hence no. of houses under management will need to increase. This is all not to mention that now you have 25+ mortgages in your name. The risk – 10 out of 25 properties suddenly loses the tenants and remains vacant for 3 months. Now you have to be able to make 10 mortgage payments every month from other sources of income for an extended period of time.
I am not saying Real Estate Investing is bad, lots of millionaires and billionaires have achieved their wealth creation through this. However you need to know yourself and act accordingly after you understand all the risks involved.
A combined approach:
Is it possible to have best of both worlds? Sure there is, if you are not in a hurry to get out of your job and have the patience to slowly build both your net worth and cash flow.
A few simple ideas which comes to my mind are below. I have done some myself and plan to do the rest.
Increase your income and live below your means. This is very obvious, yet the most difficult to do consistently.
Invest consistently 15-20% of your income into stocks, bonds and cash. See post: Emotional Investing
Live in and then rent – Convert your existing house to a rental once you move out to another one. Or just rent out a portion of your house. This has the advantage that the mortgage you have is an owner occupied one (less interest rates typically), also it is paid up consistently as you spend more years and gets factored in your regular budget. See post: Don’t twist your ARM, fix it !!!
Pay off your old houses completely but do not sell. Convert your equity play into a rental now. The paid off house will generate much better cash flow with substantially less risk, as there is no mortgage payments to worry about. See post: The Paid Piper of Hamelin
Find sources of passive income which you can buy with your accumulated savings, like investing in a profitable business, crowd funded real estate etc. These have much less risk if you do your homework, at least there is no risk of foreclosure etc.
Write a book or start an online course about your area of expertise.
In short, increase your net worth and cash flowing assets in a sensible fashion, with less to no debt and consistent action.
Here are some of my previous posts which may inspire the above principles.
