The four steps to financial stability and freedom are:
- Create an income that exceeds your basic needs.
- Maximize your free cash flow.
- Use free cash flow to save up for things that you’ll need.
- Invest the excess and create a financial feedback loop.
In this article we’ll deep dive into free cash flow: What it is, how to calculate it, why it matters, and how to maximize it.
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What is free cash flow?
Free cash flow is the money you have left over after you have paid for everything you are obligated to buy each month. This is the money you have before you pay for basic needs like food and clothing but after you have paid for rent, car payments, and so on. A company that has a lot of free cash flow is generally a good investment because they are able to be flexible and take advantage of opportunities. Just like companies, individuals who have a lot of free cash flow have flexibility in their lives as well.
Let’s say a friend comes to you with a great business idea and wants you to buy in. If you have lots of payments in your budget, such that your whole paycheck is absorbed before the month even begins, you will not be able to take advantage. If you have several thousand dollars free each month, however, you would be able to make an investment. That investment early on could result in thousands or even hundreds of thousands of dollars of income in the future. But the investment would only be possible with enough free cash flow to buy into the venture.
Having a strong free cash flow also prevents debt. If your car breaks down, you can just cover the bill if you have the cash flow. Otherwise, you might need to finance it on a credit card and pay interest payments.
Having free cash flow also lets you save money up so that when you need to buy a new air conditioning unit or replace the sofa you can have the money ready. If you have little or no cash flow you’ll end up taking out a loan for these purchases. You could make the same salary as your coworker but have more money actually going to things you want than him because he’s paying interest. You get a discount!
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SmallIvy Book of Investing: Book1: Investing to Grow Wealthy
How Do You Calculate Free Cash Flow?
As said, free cash flow is the difference between the money you have coming in each month (or year) and the money you have obligated. To calculate it, figure up all of the expenses you are obligated to pay for each month. These are things like rent, mortgages, payments for other loans, credit card payments, car payments, alimony or child support, legal judgements against you, subscriptions, memberships, taxes, and so on. Things that you would go to jail for, be sued for, or have a ding on your credit if you did not pay them. Add all of these up for the month or the year to get your total obligated expenses.
Then, figure out all of your income. This includes salaries, interest payments, income from rental units you own, and side-business income. If you have stock investments or other investments where capital gains are made, you can estimate this income as well based on historical returns. For example, you can estimate that a $100,000 stock portfolio would provide an average of $10,000 in income each year. Obviously, this value would fluctuate and you can’t rely on it for regular bills, but it will add to your net worth at about a 10% rate over time and you can draw from it to buy things and make other investments.
Should your home value be included in your income calculation? Maybe. The issue here is that while your home will be increasing in value and therefore increasing your net worth, you will always need a home and therefore it would be difficult to use your home to buy other things. Still, you could access the equity in your home with a home equity loan in the future or sell a larger home and trade down for a smaller one in retirement, so it may be worth including at least some of the gains from your home value (the excess beyond what you really need) as income when calculating free cash flow.
Once you have your obligated expenses and your income calculated, subtract the former from the latter. This is your free cash flow.
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Using your Free Cash Flow
Some of your free cash flow will go towards buying necessities. These are things like food, clothing, and electricity. Transportation expenses like getting gas for your car or paying for the subway will also come out of free cash flow. Still, these are things that you can generally adjust. You could get all of your meals out and go to fancy steakhouses or buy ramen noodle bowls for most of your meals. You could have steak and eggs for breakfast or just eggs and toast. This ability to increase or reduce how much you’re spending on these types of expenses gives you some flexibility to direct your free cash flow elsewhere as desired.
In particular, having more free cash flow will allow you to invest some of your money. When you invest, you buy assets that then generate more income and increase your cash flow even more. You can even create a feed-back loop where your investments are used to buy additional investments, which then creates more free cash flow. When you do this, your income really starts to grow quickly.
(If you’d like to learn more about how to decide how much you should put in different types of assets, Sample Mutual Fund Portfolios gives lots of information and examples of how to make allocations for all sorts of different goals, including retirement.)
How to Maximize your Free Cash Flow
OK, so how do you maximize free cash flow? Obviously you want to minimize the number of loans and payments you have. If you’re just getting started in life, this means getting a smaller apartment and saving up more for a home so that your mortgage payment is lower. It means saving up and paying for things like cars and new appliances rather than waiting for them to break and then needing to get a loan with a payment. It means just renting places when you go on vacation rather than buying a timeshare where you have maintenance fees and assessments to pay. It also means managing your budget and saving up an emergency fund so that you don’t need to go into credit card debt.
If you’re already in debt, you free up cash flow by paying those debts off. An easy way to start is to look at the subscriptions you have and start cancelling them. Do you really need all of those streaming channels? Do you need that gym membership you haven’t used in months? Do you need to belong to the tea of the month club? With everything like home products, movies, coffee, and so on can you just buy it when you need or want it rather than being signed up to buy something whether you want it now or not?
Rather than just focusing on spending, can you increase free cash flow by increasing income without increasing your spending along with it? Can you work your way into a higher paying position at your job or take another job that pays better? After there side-hustles you can do on the weekend that will increase your income? Can you make and sell something people would buy? As previously discussed, can you buy stocks and other investments to generate passive income?
Maximizing your free cash flow is one of the keys to getting on great financial footing. It is the fuel that allows your financial engines to run and produce. Without free cash flow, you can’t invest or pay cash for things you need. Focus on getting your free cash flow into great shape.
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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.
