Know Your Operations: Personal Cash Flow

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We just completed the important exercise of creating a Personal Balance Sheet. This resulted in a current snapshot in time of your entire financial picture, culminating in the calculation of your Net Worth.


However, the balance sheet doesn’t lend much insight as to how you arrived at your current financial state. More importantly, it doesn’t tell us anything about your monthly ‘operations’.

In other words, how well are you managing money? Just like a company, are your personal operations generating a profit (savings) or resulting in increased debt (losses)?


For this next exercise, we will be looking at a more detailed version of a budget: your Personal Cash Flow.

Overview

  • Cash Flow analysis is valuable for both individuals and companies.
  • Quantify how much your monthly income and expenses fluctuate (stability).
  • Pinpoint where expenses originate.  
  • Ensure net gains are being saved/invested in the best ways, aligned to what we learned from the balance sheet exercise.
  • Jump directly to the excel here to start hacking away. 

Concept.

Let’s start with understanding the basics of a corporate cash flow statement and why it’s used.
Cash flows provide a snapshot of how much cash was received and how much was spent by a company of a given time period. 

Typically, these statements separate cash into three categories:

  1. Operations: Day-to-day core activities. Selling products, buying materials, paying people…
  2. Investing Activities: Buying/selling assets, buying/selling securities, giving out loans…
  3. Financing Activities: Paying loans, issuing stock, paying dividends, collecting money from investors…

Cash Flows are useful tools to understand the performance of the organization, and provide more traceability to areas of strength and weakness. If you remember in our previous exercise on constructing a Personal Balance Sheet, we didn’t learn much about ‘how’ you arrived to your current financial state. In this sense, we can think of Cash Flow as the complement to the Balance Sheet (no surprise then why these are standard filings for companies).

Personal Cash Flows.


How do we adapt the corporate version to be useful at the household level and act more like a Swiss army knife?  First, we want our cash flow to serve two purposes:

  1. Show what our income/expenses were historically
  2. Forecast and make an updated budget plan we can implement today

Similar to the corporate model, we will categorize our cash into  ‘operations’ and ‘investing’. We can combine investing and financing activities into a single bucket for our purposes.

Purpose.

What are we trying to answer with this exercise? 

  • How much will I save in the next 3 months? How about over the next year? Gaining visibility into your net savings (or debt) is important for many reasons. If you are saving up for a longer-term goal such as a down payment, you can get a sense of how long that will take. But even more importantly, we want to make a sound investing plan. Depending on your savings and income, we can more intelligently divert savings into the right assets: cash, market securities, retirement, etc. This is why the cash flow paired with your balance sheet become the yin and yang of financial planning.
  • How consistent are my savings? We will look at variation and how much cash flow fluctuates each month. This will help give a better idea on risk and what percentage of money we should move into certain accounts (e.g. a rainy day fund). This measure will also shed light on which categories are most unpredictable.
  • Where are my biggest expenses? Pretty straightforward here. Apart from taxes, where is the bulk of your money flowing out to? There are some areas we have little control (taxes, utilities, etc) and some where there is flexibility (dining out vs. groceries). If you are familiar with Pareto and his principle, we want to focus on the 20% that is leading to 80% of your controllable expenses.
  • Where should I put my money and how much? This is the ultimate question we are answering. Based on your savings (or net outflow), and what we learned above, we will create a plan to maximize savings, reduce expenses, and balance risk.

Let’s dig in.

Walkthrough.

In many ways our cash flow format will resemble a budget, only more detailed and informed. The main difference between our format and both a budget and typical corporate cash flow, is we will be looking backwards to forecast forwards.  This helps us not cheat the system by under or over estimating certain expenses.

  • Blend between a corporate cash flow statement and a forward-looking personal budget.
  • We will use the past 3 months of actual data to forecast the next 3 months. Using a quarterly cycle should give us enough of a sample set to forecast a yearly savings estimate. 


Let’s continue with our fictional Jim case study from before. We will look at Jim’s fictional income and expenses for the last 3 months to 1) forecast his future savings and 2) make a recommendation to Jim for what to do with his cash each month.

If you want to follow on step-by-step for your own purposes, here’s what to prepare:

  1. Grab bank statements and/or credit card statements from the last 3 months.
  2. We will go through all income categories first, and then tabulate expenses. If your bank offers a nice exportable, categorized list of your transactions, this will be very helpful.
  3. The total exercise will take 2-4 hours depending how detailed you want to be.
  4. *It’s important to note that all of these items should capture your household income/expenses, so make sure to grab your spouse’s information if need be.

Let’s start with money coming in.

Inflows.

Inflow cash is any type of income, whether it is recurring or sporadic. We want to capture all employment gross wages, side hustle income, retirement distributions, social security and any other income events like a tax refund or birthday gift.

As we noted above, we’ll break these into two main categories: operations and investing income. It’s important to do this to capture how much income is being earned passively (time = $) versus actively (your time = $).


Most of us will have a stable salary each month. Since Jim is in sales, his income will fluctuate a bit more each month. We’ve captured his last three months in earnings which show a significant sales commission two months ago. Jim was also told that his base salary would go up by $200 each month given his performance over the last year.

We take the average of the last three months here, and add the bump in pay to forecast an average income of $5,733.

Jim keeps most of his savings in a standard interest bearing account so the interest from that is captured here as well. Since the balance will increase each month, so will the interest – the power of compounding.
Jim doesn’t have a side business, and he wasn’t a famous recording artist or inventor in a previous life, so no royalties either. The only other income from the last few months was his tax refund of $400.  Since this is a once a year inflow, we will take the equivalent monthly income for our future month projections.
That’s it for inflows!

Probably a good time to take a break if you need to stretch your legs. Expenses are tedious and require caffeine.

Outflows: Wage Deductions.

We’re going to group expenses in similar buckets as income: operational expenses and financing expenses.

Your operational expenses can be thought of in the same way as a business – what expenses are unavoidable aka the cost of doing business, and what are the expenses associated with running your household?
Let’s start with the usual suspects: payroll deductions (unavoidable).

These expenses are all items that are pulled from your gross wages (total before any taxes etc.). All of this information will be on your paystub so it’s recommended to use those actual figures. The workbook has taken some liberties and assumes an 18% federal tax rate for Jim, and a 2% state tax rate. These numbers will be different for you, but are useful placeholders.

The other elements here to note are medical insurance deductions, HSA accounts, and most importantly employer-sponsored retirement accounts (401(k), 403(b), Roth 401s, etc.). While these are ‘deductions’ you aren’t losing the money, and they shouldn’t be thought of in the same way as say, buying eggs. Similarly for HSAs, you retain access and utility of the cash in these accounts, so we think of it more as a reallocation and not an expense. Don’t worry about this for now, just file that away.

Jim’s deductions here are just functions of his wages we captured above. He is fortunate and has an employer sponsored plan and diverts 4% of his salary to a 401(k), so we’ve grabbed that as well as $20 a month into an HSA. Jim figured this would cover a few co-pays over the year and a prescription.

Outflows: Business and Financing.

If you have a side business (sole proprietorship or LLC) or rental property, we’ll want to capture those pass through expenses here. Along with business outflows, our personal financing and investing activities include your mortgage, car payments, student loans, and credit card interest. These types of expenses are generally static (not changing each month), so we’ll carry the same amounts forward.

Important to note that if you are paying your credit cards in full (as you really really should), this should be a $0 balance each month. We’ll want to itemize items you purchase on credit into their respective category in the next section.

Like most young professionals, our fictional Jim is a renter, is paying off a car, and has student loan debt, so those amounts are captured in their respective spots here.

Not so bad.

Outflows: Household Operations.

Ok, this part is pretty bad.

We’ve got all our other types of expenses that should be most familiar. No secret here other than brute force. Arm yourself with last 3 months of transaction statements and go nuts.

Now if you want to cheat a little, feel free to estimate some of the smaller expenses or even items like utilities. The more important categories for accuracy are groceries, entertainment, and insurance. Basically, recurring but dynamic expenses.

What we’ll do here for those one-off expenses such as auto maintenance, is spread that expense across the year to find an average monthly equivalent. That said, since we are only looking at the last several months we may miss some of these large, one-time expenses. If that’s the case, I would suggest adding in something from the past year if you think there is a chance a similar expense could reoccur. Think along the lines of home improvement or vacations. It’s important to budget for these, and they can have a heavy influence on how we plan going forward.

Here’s a look at Jim’s situation:

After all is said and done, Jim has saved an average of $866 the last 3 months and projecting to save just over $1000 a month going forward.

If you’ve made it this far, we’re basically done. Now it’s time to look at what this all means and translate it into something actionable. Analysis. We want to look at two main things:

  • What is your projected cash flow over the next year?
  • How consistent and predictable is your cash flow?

Projected Cash Flow

Looking at our example, Jim is projected to save $13,238 over a twelve month period. I won’t bore you with the exact details on how this is calculated, but it is more or less looking at the rolling average over previous six months to forecast ahead the next month’s cash flow (You can look at the formulas in the ‘Forecast’ tab if interested. It’s imperfect so feel free to tweak how this is done). This forecast also takes into account some of the variation in savings/expenses over the last quarter.

*If you’ve followed along so far, all of these calculations will be done for you, simply reference the ‘Summary’ tab on our workbook.

Consistency

This is another name for volatility/variation or risk. If we are going to make a plan, we need to rely on future cash flows. When our previous months expenses and income vary wildly, it reduces confidence in what these will look like going forward.

In general terms, we want to minimize the variation percentages for cash flow, income, and expenses. This equates to these items being more predictable and steady. All good things.

Looking at Jim’s situation, we can see the following metrics:

Jim’s expenses are quite stable and reliable, but his cash flow and income are changing by much larger percentages. For those of us who aren’t salesmen or say real estate agents, this would be concerning, but working on commissions is inherently risky, so this is to be expected here. If you are on a normal monthly salary or hourly equivalent, income variation should stay under 10%.

In any case, we don’t want to see the variation in cash flow to rise above 100%. That would imply too much risk and most likely some months having a negative cash flow.

Perspective.

As always this isn’t an exact science. You should use these metrics as a guide to asking yourself the right questions related to your unique situation. It should also be noted that depending on the scale of your income/expenses, small changes in cash flow will have a much larger or smaller effect on these risk metrics.

For example, if you earn $1000 per month, a $100 change in income or expenses will have a 10% impact on your cash flow. You can imagine now the $100 change if you were making $10,000 per month is negligible. This also extends to how seriously we view the risk metrics.

To account for this, we look at another metric: savings percentage per month.

We get a better idea with these metrics of how well cash is being managed overall. We want this to obviously be a large percentage, ideally at least 15%, and we want the volatility to be less than your savings percent. In Jim’s case, he is saving about 15% on average with a volatility of ~8%. If volatility was greater than 15% in Jim’s case we would know that some months he could have a negative cash flow.

Plan.

If you’re unhappy or worried about what we’ve learned from above, hopefully you have a better idea on how to positively influence your cash flow at this point.

On one hand, it’s not complicated. If you either a) make more money or b) spend less, your cash flow and savings will go up. However, don’t forget that consistency is just as important. Reducing risk is valuable. The easiest way to do that is being aware of your operations, and making small habit changes that can slowly keep things more consistent.

In the next stage of our investment planning journey, we will use what we’ve learned here to help define how much of your positive cash flow should go into a) cash accounts, b) securities, and c) retirement. For example, if you’ve found your cash flow is very unpredictable, it would make sense to keep your savings in more liquid vehicles as opposed to real estate. More on all this jazz later!

Your Turn.

I know these first few exercises are intense and tedious, but hopefully you have found them valuable. Luckily, you won’t need to go through the balance sheet and cash flow exercise very often, no more than once a year unless you are experiencing a major life event. In which case, it makes sense to revisit.

Again, here’s a link to the spreadsheet, download or make a copy for yourself and hack away.

As always, reach out with any questions, would love to help!

Dig Deeper.
Corporate Cash Flows
Compound Interest
HSA Accounts

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