Now that we’ve covered the importance of measuring and tracking your net worth, let’s move on to a financial measure that’s almost as important.
It’s important because it’s a major driver of net worth. It’s called cash flow.
What is Cash Flow?
Cash flow is simply income minus expenses. It’s what you make/earn less what you spend. Income less expenses. The difference between these two is your cash flow.
Consider this example:
- Monthly income: $4,000
- Monthly expenses: $3,500
- Monthly cash flow: $500
You build your wealth (net worth) by taking your cash flow and investing it. This is how it fuels the growth of your net worth. It’s cash flow (and the saving/investing of it) that buys homes, investments, and the like that drives net worth.
By the way, I’ll also use the term “gap” to refer to cash flow. I like it because the word describes exactly what it is — the gap between income and expenses. And the larger the gap, the better.
Two Key Parts of Cash Flow
The two vital parts of creating a strong cash flow are maximizing your income and limiting your expenses. If you can grow the former and keep the latter in check, your cash flow will skyrocket, fueling your net worth to new and glorious heights.
Now’s a good time to relate these principles to ESI Money. I’ve already explained what ESI means, but I’d like to cover it again in a different way. Consider the following:
- E – You want to EARN as much as you can
- S – You want to keep your expenses low so you can SAVE as much as you can
- I – You take the gap between “E” and “S” and INVEST it to grow your net worth
Makes sense, right?
How to Track and Manage Cash Flow
Now we’re going to get vulgar. I’m about to say a dirty word. Probably the dirtiest word in finance. Ready? Here it is: budget.
I know, you’re cringing. Just stick with me a few more paragraphs. It’s not as nearly as bad as you think.
The budget is the most used method for tracking/setting/managing cash flow. It’s widely hated because people see it as a taskmaster, a plan that tells you “don’t do this” and “don’t do that.” It’s seen as a kill-joy.
But it’s really the opposite. The budget helps you cover your mandatory expenses, then decide what else you want to spend your money on. Yes, you decide what else to spend money on. The budget doesn’t decide, you decide.
Better yet, you don’t have to keep a budget all your life. (See, I told you it would get better.)
My belief is that in the early years of managing your own money, a budget is invaluable. It will help you see where your money is going and how it’s spent. The budget will help you catch expenses that otherwise might not be noticeable. It will help you make good financial decisions.
I highly recommend having a budget for people just starting out handling their money since it’s vital to understand and manage your money very tightly early on. I would make it as detailed as possible and review/update it on a regular basis (like monthly.) This is what we did for the first decade or so of our marriage. It made a huge difference in how we manged our money and the financial results of those efforts.
After you become a bit more proficient at managing your money, I think you can go to a less detailed and less frequently updated budget. If you’ve proven that you can manage your money (and especially control your spending) a budget isn’t needed nearly as much to ensure your cash flow remains strong.
I’d ease into this process by updating and reviewing a budget quarterly, then semi-annually, then annually. If you get really good at creating a surplus and watching your spending, you can eventually get to the point where you don’t need an official budget at all — you can simply review spending in real-time as needed. This is what we currently do. We look at spending in Quicken and make adjustments as needed, but we don’t have a formal budget.
Finally, as you begin to approach retirement (or early semi-retirement), you’ll need to go back to the basic budget (as I’ve done — here are examples for 2017 and 2018). You’ll want to be 100% sure that your income and expenses are where you want them to be before you make any major moves because once you do, it’s hard to go back (for instance, hard to go back to work, hard to cut expenses that are now fixed, and so forth.) For these reasons, I suggest you do a very detailed, multi-year budget well before retirement to see if you can afford to make the changes you want to.
How to Develop a Budget
To begin developing a budget you need to track your spending for 30 days.
For 30 days write down both the amount and the payee (where the money went) EVERY SINGLE TIME you spend money. When you pay your mortgage with a check, write it down. When you transfer money to your utility company via your bank, write it down. When you pay for a coffee with a credit card, write it down. When you put $1 into the vending machine at work, write it down. When you give your son a quarter to buy a gumball, write it down. Write down every single time you spend money for 30 days.
If you’ve never done this, believe me, it will be very enlightening. It will show you where your money is really going (versus where you think it is going.) I’ve had many people do this exercise over the course of the past 20 years and there are ALWAYS surprises — even for those people who think they know where every penny is going.
So write down your spending (and if you’re in a family, this includes everyone in the family who spends money) for the next 30 days. Don’t question it. Don’t dismiss it. Just do it. If for no other reason, simply humor me and do it.
After 30 days, figure out how much you make each month, and then use the information you gathered from tracking your spending (as well as by looking at past records) to calculate the amount you spend each month. Subtract the latter from the former and what you have left over is your monthly gap (hopefully it’s a positive number.)
If your gap is negative, low, or simply in need of being increased to super-charge your savings, the only two ways to improve it are to increase income and/or cut spending. And that’s what we will discuss on this site — ideas on how to increase income and decrease expenses.
How Everything Fits Together
Over the past two posts we’ve highlighted several personal finance basics. Here’s how all the financial pieces fit together:
- A budget allows you to see where your money comes in (and how much and when) and where it’s spent. It’s the mechanism for determining and tracking your cash flow.
- Your cash flow reveals the surplus (income less expenses) that you have each year to be saved/invested.
- These savings/investments increase your net worth and, over time, allow you to become wealthy.
- By tracking cash flow on a regular basis (with a budget) and using the information generated to make appropriate adjustments, you can take steps to significantly grow your net worth over time and ultimately meet almost any realistic financial objective you set for yourself.
Now that we’ve covered what makes up cash flow, we’ll begin discussing the key elements of it — and the first two letters of this site’s name — earning more and controlling spending. This is where it really gets fun.