Rethinking Retirement  

FM 102: Cash Flow Statement

Understanding Your Personal Cash Flow Statement

A Personal Cash Flow Statement (PCFS) is the second of two basic financial statements that are vital to one's financial security. Along with the Personal Balance Sheet (PBS), understanding these two financial statements is the first step to gaining the knowledge necessary for financial maturity.

A PCFS is nothing more than an accounting of all your cash inflows (income) and outflows (expenses) over a given period of time. Most PCFS's are done on a monthly basis, but others are done quarterly, annually or semi-annually. The key is to make sure you do them often enough to maintain a strong understanding of your cash flow.

In terms of format, all sources and amounts of income for the timeframe being examined are listed on the left hand  side of the page, (or in some formats, the upper part of the page) and all the expenses are listed on the right hand side  (or lower portion) of the page.

Subtracting your total expenses from your total income for the period will provide you with a net cash flow number. Obviously, a positive  net cash flow (meaning income is more than expenses) is required to accumulate assets, payoff debts and build your net worth.

Compared to the expense side of the PCFS, the income side is relatively simple, so let's start there. All sources of  income can be divided into three broad categories: earned income, investment income, and other income. 

Earned Income is compensation earned from  employment, which includes wages, salary, tips, and other compensation. Earned income is often considered the conversion of human capital into financial capital.

Investment Income, for purposes of our PCFS, includes any income withdrawn from the Investment Assets of our Personal Balance  Sheet. For our investment portfolios of stocks, bonds, mutual funds or other intangible  financial assets, this income can come in the  form of dividends, interest or even systematic withdrawals of principal. Income from rental real estate properties is also considered investment income.

Finally, Other Income would include things  such as pensions and social security  benefits.

For most of us, our financial goals are driven by the desire to one day be financially independent. But what exactly does that mean? Very simply, it means that you've been able to generate enough investment and other income to meet your ongoing total expenses for the rest of your life. As such, there is no single "rule of thumb" number that represents financial independence. The number is different for each of us depending on our lifestyle and expenses. Therefore the only way to know how close you are to financial independence is to track your current expenses and anticipate your future expenses very carefully.

The expense side of the PCFS can also be broken down into two broad categories: fixed expenses and variable expenses. Each of these is then divided even further.

Fixed expenses are those expenses that are a permanent, fixed part of your budget. The exact amount of the fixed expense may  fluctuate, such as the exact amount of your phone or heating bill each month, but regardless of the amount, the expense will be there. Fixed Expenses can be broken down into the following four sub-categories.

Savings Expense. While most people don't think of savings as an expense, the financially mature do. They know that the only way to accumulate wealth (other than have it given to you) is to save on a regular basis. As such, the first payment that should be made every month is to yourself. Set up separate accounts for each financial goal that you have - retirement, college education, vacation, new house, new car, etc. - and contribute to those accounts every month. Remember also to save in both qualified and non-qualified accounts to create flexibility and provide options for any future job or career changes you may consider.

The second group of fixed expenses are Periodic Expenses. These are normal expenses that don't occur on a regular monthly basis. Many people choose to pay their insurance premiums, property taxes, homeowner’s association dues and other expenses on an annual, semi-annual or quarterly basis. Even though these bills are not due each month, we need to accrue for these expenses by saving toward them each month. Credit unions and banks have long advocated this practice by offering Christmas Club or Vacation Club accounts that allow you to save money toward a specific purpose throughout the year. One of the most critical periodic expenses that needs to be saved for on a monthly basis is the emergency fund. Things happen in our lives that we don't expect, and they're often very expensive. Regularly contributing to and maintaining an emergency fund will help to avoid pulling out the credit card and going into further debt when unexpected expenses do occur.

The third type of fixed expense is our monthly Debt Service. Debt service is simply the total amount of monthly  payments required to pay back all the money we've borrowed. These include your mortgage, car payments, credit cards and all the other loans listed on the debt side of your Personal Balance Sheet. For many, their monthly debt service consumes the majority of their monthly income. Unfortunately these are the same people who often say they feel trapped by their financial obligations. By paying off and limiting the amount of debt you carry you are able to free up more of your monthly cash flow which allows you to pursue the things you truly want to do.

The final type of fixed expense are Recurring Expenses. Recurring expenses are those monthly bills such as utilities and insurance that pay for services as you use them. The amount of each recurring expense may vary from month-to-month, but unless you stop using the service (i.e. - disconnect the phone) the bill will be coming.

The second broad category of expenses are Variable Expenses, which can be broken down into Necessity Expenses and Discretionary Expenses. A distinguishing characteristic of variable expenses is that they often occur more than once per month.

Variable Necessity Expenses are things like food, basic clothing, transportation and medical expenses. The amounts may vary significantly from month-to-month, but unlike the phone or cable TV, we can't really choose not to eat. Often we'll make several trips to the grocery store, or fill the car up with gas every week. Monitoring our variable necessity expenses require that we track our spending in these items throughout the month.

Variable Discretionary Expenses are where both the most problems and most opportunities lie. Variable discretionary expenses are things like dining out, entertainment and recreation. The problem with discretionary expenses is that  these tend to be the source of "leaks" in our cash flow. The daily latte or impulse purchase often adds up to significant amounts over the course of a month. These leaks may or may not be adding significant satisfaction to our overall  lifestyle. The opportunity lies in both curbing our discretionary spending on items that don't add to our overall lifestyle satisfaction, and consciously directing that spending toward things that will add to significantly increasing our lifestyle satisfaction.

Because so much of our lifestyle satisfaction is derived from our discretionary spending, we should strive to increase the percentage of our income that we're able to comfortably allocate to it. Not, of course, by spending money we don't have, but by decreasing the amounts obligated elsewhere. Regardless of the amount of your total income, if 95% of it is obligated to debt service, recurring expenses and variable necessity expenses, there is little left over to support the things that add to your quality of life. You feel trapped by your obligations. If, on the other hand, you've limited your total expenses to 50 or 60% of your total income, you now have excess disposable income that you can use to pursue those things that are truly meaningful to you.

If you're looking to make a major life transition to a new career or retirement, reducing your total monthly expenses provides more options as to when you might be able to make that move.

When creating your PCFS, there a couple of things to keep in mind:

1.  Make sure you include ALL your expenses. Periodic expenses in particular have a tendency of being overlooked.

2.  Don't count on income that isn't assured. Bonuses, commissions or other windfalls of income may not be consistent. If your cash flow would turn negative if those things were not present, it's likely you may be pushing your cash flow a bit too hard.

3.  You can download a workable Microsoft Excel Spreadsheet of a sample, pre-formatted Personal Cash Flow Statement by clicking here.


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