One of the most interesting parts of financial planning is cash flow management. It’s where personal values are the most visible and where the most important planning decisions are made. This is the first of three posts which together might be titled: What Your Mother Never Told You about Cash Flow Management But Would Be Really Helpful for You To Know.
Here’s the first big idea:
There are only three kinds of expenses: ones you have already agreed to pay, ones you aspire to pay, and ones you decide to pay on the day to day. If you are short on cash for one kind of expense, you have to take it from another kind.
Expenses that you have already agreed to pay—in essence your personal overhead –typically suck up the first, and often, major part of your income: housing and commuting costs, income taxes, cell phones, insurance premiums, gym fees. The higher these expenses are relative to income, the tighter your budget is on the day to day and the harder it is to save for a future expense—or to enjoy a discretionary splurge expense on the spur of the moment. It matters what you decide to incur as overhead expense.
Expenses to which you aspire might include such expenses as a secure retirement, a nice vacation next year, or perhaps cash for holiday gifts, a new car, or cash to fund an anticipated career change. To achieve these aspirational goals, it is usually necessary to have a savings plan. Goals like these don’t get funded just by chance or with cash leftover after all other spending is complete. Clarity about the importance of each goal informs how you manage daily savings. The more strongly you feel about being able to fund an aspirational goal, the more sure you’ll want the savings plan to be.
It also helps to recognize a central challenge of financial planning. None of us are very good at imagining our future selves or lives. The farther out an aspirational goal, the harder it can be to have the goal feel real on the day-to-day. For example, it’s hard to save for retirement when you are still early in your career and can’t even imagine being old. Yet retirement now typically lasts 20 years or more. That’s a long time to fund the most common of all aspirational goals. Finding a way to save early and often for highly valued long-term goals is prudent –but given human nature also really challenging.
Expenses you decide to make on the day-to-day are discretionary. You don’t have to buy that cappuccino, go out for that dinner, give that gift, or buy that appealing piece of clothing, but you might want to do so and with well-managed cash flow, you’ll also know if you have sufficient cash available for that expense. Part of the joy of financial planning is being able to enjoy day to day life in the present while also safely funding future goals. Without savvy cash flow management, however, it can be challenging to see the right balance between current and future spending on the day-to-day.
Savvy cash flow management means first of all understanding the nature of each personal expense: Overhead, Aspirational, or Daily Discretionary, and setting up an account structure to reflect these distinctions. Since you have already agreed to pay overhead expenses, it makes sense to have the payment of those expenses set for automatic payment. For aspirational expenses, you need clarity about how much you are able and willing and need to save in order to meet those future expenses. Daily discretionary spending is often done naively, in the dark, without clarity about how much cash is actually available to safely spend for discretionary items. But with savvy cash flow management, you do know how much is available for discretionary spending and can also fully enjoy the spending of it.
In financial planning, as with any other endeavor, it’s helpful to have metrics. One of the most useful financial planning metrics is monthly discretionary cash flow, i.e. the amount available for discretionary spending after all overhead expenses and aspirational savings have been addressed. Monthly discretionary cash flow is the best single financial metric for financial freedom. Early in your career it’s what’s left over after you pay likely high housing and commuting expenses and also often student debt payments. Monthly discretionary cash flow typically starts small, and then gets larger as your career unfolds. In retirement, knowing your monthly discretionary cash flow involves knowing not only one’s expenses and the nature of each but also how to safely convert portfolio wealth into sufficient lifetime income to pay personal expenses. But the metric is the same: how much free cash flow is safely available after all overhead and aspirational expenses are well addressed. The higher that number the higher is your personal financial freedom.
Do you know your current monthly discretionary cash flow?
Originally published: November 26, 2014