How you handle your cash flow is the key to whether you will work all of your life and retire with nothing or you’ll be financially independent years before you retire and have no worries financially for the rest of your life. For this reason I’ve started a new series of posts on cash flow and how you create a wealthy cash flow that builds wealth instead of a middle class cash flow that never causes any real gains in your wealth. To find all posts in this series, simply choose the cash flow category from the list in the sidebar to the right.
In this inaugural post I’ll discuss the cash flow diagram and the several boxes that make it up. Additional details are included in the book, The SmallIvy Book of Investing, Book 1: Investing to Grow Wealthy. The backbone of the cash flow diagram is the budget, which is the start of any financial plan. The cash flow plan, however goes further than a budget. Where a budget just shows how money flows in from work and then is allocated to different expenses, a cash flow plan shows how money flows through your bank account, into various investments, and then back into income to add to the money coming in. It is this recirculation of money, building on itself with each cycle, that allows you to become financially independent within your lifetime.
I recently created a cash flow diagram in a spreadsheet, as shown in the figure above. This allows me to total the different boxes and determine my family’s free cash flow, which is the money that is left over after expenses I cannot avoid and required investments are made. (Note that the cash flow diagram includes “required investments” for things like retirement and college since these are expenses that will come due and simply hoping things will work out when the time comes is not a good plan.) I’ll now go through each of the boxes in the diagram:
A. Income: Obviously this is your income for the month or the year. This includes income from work and other activities, along with investment income. The goal is to grow investment income to the point where work income is no longer needed since that will be point where you become financially independent.
B. Cash on Hand: This box includes bank accounts and other liquid assets. This is where money rests until being spent or invested.
C. Obligated Expenses: These are expenses that you must pay or you pay a fee or get thrown in jail.
D. Necessary Expenses: These are expenses that you need to pay to survive, like food, but you have some flexibility on the amount and how you cover a given category.
E. Optional Expenses: These are things you really don’t need, but which make life better, like movie tickets.
F. Required Investments; These are investments you should be making for big expenses that you’ll face eventually, like retirement.
G. Saving and Investing: This is the money you put away to generate an income and become financially independent. It is also the saving you do for big expenses like your next car to keep you out of debt.
So there you have it – the basic cash flow diagram. Note that money flows in through the top into your bank accounts, and then whatever doesn’t stay in your bank account flows out to expenses and investments. Because most people don’t see their regular bank accounts grow each month, they have formed an equilibrium where money flowing in equals money flowing out. People who spend more than they make will have debt instead of savings, which will act like a big suck on their ability to create wealth.
Your free cash flow calculation, which is shown in the upper right, is the money left over after you pay required expenses and investments. This is the money you have available to become financially independent. The bigger your free cash flow, the more quickly you can build wealth.
In the posts that follow in this series we’ll talk about how to use a cash flow diagram to understand your finances and put yourself onto the path to become wealthy.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
