Personal Cash Flow Basics

Personal financial literacy is the first step towards developing true financial security and realizing a dream of quitting a job or having a comfortable retirement. I received an MBA in accounting and now I use my knowledge to help others. People and businesses have a lot of difficulty managing cash flow. Even though most people have an idea of what they make and spend, timing issues can occasionally cause bounced checks, rejected payments, and other issues. In the worst cases, individuals resort to using credit cards or payday loans to smooth income, but this tends to cause more problems than it solves.

You might ask what makes me an authority on cash flow? Besides having an MBA and a strong background in economics, finance, and accounting, I am one of the few people in the world who has never had a missed or late payment. Among other things, my credit reports routinely show no negative items and no late payments. Looking back over my late high school years and college years this is astonishing because I made many of the mistakes that young people make with credit (e.g. eating out on credit cards, financing a car through the dealership, "12 months with no interest," etc.). Ultimately I made it through because I had a good sense of cash flow management and effectively managed inflows and outflows. I even had the foresight through the cash flow modeling process to change jobs to higher paying positions months in advance of upcoming financial issues (due to rent increases and other major changes in expense composition).

This post will be less about the statement of cash flows than cash flow planning because individuals are forced to operate on the cash basis of accounting either indirectly or directly. Planning and timing are more important than retrospective analysis for individuals. Businesses use a statement of cash flow to show how cash actually moves in and out of a business since the numbers on an income statement differ significantly from actual cash flow. The income statement includes a lot of non-cash items like depreciation, certain unrealized gains and losses, and really unintuitive things around consolidation and pensions that do not affect cash (or distort the actual change in cash). For the most part, individuals prepare their balance sheets and income statements on the cash basis or on a fair value basis (vs. the historic basis that companies use). This basis typically reflects:

• Income/expenses measured on the receipt/disbursement of cash
  
• Fair value of investments, vehicles, and real estate property if they were to be converted to cash (sold). Changes in fair value recorded directly in equity.
  
• Settlement amount required for liabilities (e.g. pay off a mortgage or car loan today)

Going back to the bookkeeping example, John Doe would immediately expense all of the prepaid insurance under the cash basis when he wrote the check instead of making adjusting entries. Interest would also be treated differently on the income statement example because the loan payment and the interest would both be expended instead of offsetting the principal payment against the liability on the balance sheet.

So why does cash flow timing cause so many problems?

Let's take a simple example where John Doe starts a new job that pays around $4,000/month after taxes and he is paid on the last working day of the month. I use this example because I faced the exact same situation with my last job change where I changed from bi-weekly to monthly pay. Let's also say that John Doe has $3500 of bills that are mostly due on the 1st, 7th, 15th, and 28th days of the month. Before John can even take the job, he needs to have $3,500 in cash sitting in checking or savings, or else he will be stuck incurring $3,500 in payday loans or credit card debt during the first month of working in order to cover bills. This is a bad situation to encounter. Typically cash inflows spike throughout the month (for biweekly employees) and the average individual can handle a pay lag of 2 weeks much more easily than 1 month. Planning a missed paycheck (especially a monthly one) can be very difficult if things are tight.

Ultimately the key to controlling cash and preventing late payments is to identify all inflows and outflows and the day(s) of the month that they need to occur. Then a spreadsheet or database can be kept that shows the projected amount of money that needs to be kept in an account at any point in time based on budgeted inflows and outflows to support on-time payments for everything. It is not necessary to track things down to the day. For many years, I used a spreadsheet that showed by-weekly inflows/outflows and I showed all outflows going out the pay period before they were due. Additionally I used the conditional formatting feature of Excel to tel me if my projected account balance was ever below a minimum threshold (in my case I chose $100). Using this strategy I could also easily plan out debt payoff scenarios and understand what was left to go to savings and other purchases.

If cash outflows are systematically greater than inflows, then changes need to be made. Bills need to be reduced or a higher income needs to be sought from a job change or a business expansion.

Good cash flow management is only part of a solid financial picture, effort also needs to be made to ensure that expenses (not necessarily cash flows) are kept below monthly revenues so that bigger replacement purchases (ex. cars, appliances, computers, etc.) don't create a balance sheet problem when they need to be made.

See Also
Retirement in the 21st Century
The Personal Balance Sheet
The Personal Income Statement
Basic Bookkeeping for Everyone