I’ve written a lot about the power of getting your personal finances in order. These ideas literally changed my life.
For years, I had naively convinced myself that everything would just “work out” somehow.
I had a great, high-paying job and was steadily climbing the corporate ladder. Why did I need to worry about saving for retirement or living within my means?
But the reality is this: When you don’t take care of your finances in the present, you’re actually robbing your – and your family’s – future.
I had to learn that lesson the hard way. But I don’t want that to happen to you. That’s why I’m so adamant about the importance of getting out of debt and saving for a “rainy day.”
To me, these simple steps are among the most important you can take toward a better future. In fact, I believe most folks should focus on these areas before they even think about investing a significant amount of money in the markets.
But as critical as these things are, there is actually another step that should come before them.
It has to do with the concept of “cash flow.”
Longtime readers know I love the idea of investing in “forever stocks.” I aim to buy shares in high-quality companies that are likely to survive and thrive over the long run regardless of what happens in the economy along the way.
One of the defining characteristics of these types of companies is the ability to generate strong, consistent “free cash flow” through good times and bad.
Free cash flow is how much cash a company brings in after accounting for the costs of running its business (operating expenses) and buying or maintaining physical assets like buildings and equipment (capital expenditures).
Unlike net income (profits) and some other common financial health metrics, free cash flow isn’t easily “massaged” or manipulated.
A company is either generating real cash, or it isn’t. And if a company isn’t consistently bringing in more money than it’s spending to run and maintain its business, it’s unlikely to do well for long.
Well, a simpler version of this same idea can help with our personal finances as well.
You’re likely familiar with the age-old advice to “spend less than you earn.” It’s a bit cliché, but it’s true.
Positive cash flow is the foundation of personal financial health. If you’re spending more money than you bring in each month, then trying to pay off debt, build a rainy-day fund, or invest for retirement is an exercise in futility.
Calculating your personal cash flow will help ensure your foundation is solid.
Fortunately, it’s relatively easy to do. And unlike following a budget – which I’ve personally never been able to stick to for long – it doesn’t require a significant ongoing commitment.
Calculate Your Monthly Net Income
You first need to figure out your monthly “net income” – that’s how much money you bring home each month after taxes.
You’ll start by listing all sources of regular income you earn that are available to spend. Examples include your primary salary, income from secondary or part-time employment, social security, child support or alimony, dividend or interest payments (that you aren’t reinvesting), rental income, etc. Just be sure to deduct taxes for any income that doesn’t already include automatic withholding.
Once you’ve done this, calculating your monthly net income is as simple as adding up all these various sources into a monthly total. However, if your income is variable or irregular, you may want to take an average of six to 12 months or more.
Calculate Your Monthly Expenses
Next, you’ll tally up your average monthly expenses the same way.
First, you’ll list out your fixed or “non-discretionary” expenses. Common examples include rent or mortgage payments, loan payments (credit card, auto, student, and personal loans), insurance premiums, child support or alimony payments, and utilities, medical, transportation, and food costs.
Next, you’ll list out any “discretionary” expenses. These can vary significantly from person to person but might include dining, entertainment, travel, miscellaneous shopping expenses, etc.
Again, you’ll add all these expenses to find the monthly total. However, because they tend to be more variable than income for many people, I would generally recommend taking an average over at least three months for better accuracy.
Calculate Your Monthly Cash Flow
Now that you’ve calculated these figures, you’ll simply subtract your average monthly expenses from your average monthly income to calculate your monthly cash flow.
This is how much money you actually have to work with each month.
Ideally, you’ll find that the result is a healthy positive sum. However, if your monthly cash flow is less than you’d like – or worse, if it’s a negative number – you have some work to do before you do anything else with your finances.
How to Improve Your Personal “Cash Flow Statement”
Obviously, there are two primary ways to increase your monthly cash flow. You can earn more money (increase your monthly net income), or you can spend less of the money you already earn (decrease your monthly expenses).
The first place I recommend looking is in the list of discretionary expenses you made earlier.
If you’re like many folks, you’ll probably find you’re spending money on luxuries and unnecessary items that you don’t enjoy that much.
That’s what my wife and I found when we started looking at our own cash flow several years ago. And it prompted us to make a simple rule that we still live by: If we are going to spend money on a nonessential item, it must be something we love… something that truly brings us joy.
What we found surprised us. It turned out that many of the things we bought didn’t make us happy, and many of the things that brought us joy didn’t cost much at all.
For example, spending time with friends is one of our greatest joys – and we found that doing that over an inexpensive home-cooked meal was often more enjoyable than going to an expensive restaurant.
If you take a closer look at your spending, I suspect you may be surprised by how much you could cut without negatively affecting your quality of life.
It’s also worth taking a closer look at your non-discretionary spending. There may be relatively painless ways to lower even these expenses. Examples might include consolidating or refinancing high-interest-rate debt, “shopping around” for better utility or insurance rates, working from home part-time or carpooling to save on transportation costs, etc.
Of course, depending on your financial situation, cutting expenses may not be sufficient to move your monthly cash flow to where you want it to be. You may need to generate more money by seeking a better-paying job, taking on some part-time work, or starting a “side hustle” of some sort.
As I’ve mentioned before, I’ve always worked hard to generate more income. There’s no roundabout way to do this. If you need more money, you have to go earn it!
Finally, once your personal cash flow statement is healthy, there’s no need to revisit it unless your income or expenses change significantly. You can then get to work using your cash to begin working toward bigger financial goals like paying off debt, saving for a rainy day, or investing for the future.
As always, if you have any questions or comments on today’s editorial – or any previous Money Talks topics – I’d love to hear from you. You can reach me directly at [email protected]. I can’t respond to every email, but I promise to read them all.