Steadfast FinancesPersonal Finance Equations You Should Know: the Cash Flow Equation

Personal Finance Equations You Should Know: the Cash Flow Equation

Filed in Budgeting , Personal Finance , Saving Money 9 comments

Paying bills is a fact of life. We all have them, and we’re required to pay them. Otherwise, after a few months of not paying them, you’ll probably find yourself sitting in a cold, dark house with no electricity, no water, and probably not have a house/apartment to sit in much longer.

Therefore, keeping track of how much money you’re paying out versus how much money you’re bringing in is crucial. If handled poorly, you might find yourself spending more money than you’re making, resulting in an in-the-red monthly budget. On a long enough time line, if you repeatedly spend more than you make, you will eventually exhaust your cash reserves (e.g. emergency fund) and will need to seek alternative sources of funding (hitting up family for loans, living off of credit cards, etc.).

In financial lingo, this method of knowing how much you make versus how much you spend is referred to as cash flow.

So if you have ever paid an overdraft fee on a debit card, bounced a check, or couldn’t sleep at night because don’t know if you’ll have enough money left over at the end of the month to pay your bills, it’s definitely a personal finance equation you should learn ASAP.

Mathematically, the cash flow equation couldn’t be simpler:

where…

Incoming Income = Primary Salary + Secondary Salary + Passive Income + Interest Payments + Stock/Bond Dividends. Any other sources of income should be included in this sum.

Outgoing Expenses = Mortgage/Rent + Car Payments + Insurance + Utilities + Food Expenses + Gas. Any other outgoing expenses should be included in this sum.

Using the Cash Flow Equation

Obviously, you will need to spend a few minutes gathering all of your financial data, but it’s definitely worth the time investment. Once you do, list all income in one column and all expenses in a second column. Once you have everything in place, calculate the total funds for each column.

Then, simply subtract your total monthly expenses from your total monthly income.

As you can see in this example, this person would be cash flow positive since their incoming funds is greater than their outgoing expenses.

What to Do if Cash Flow Positive?

If you’re fortunate enough to be in the black (cash flow positive), then you’re going to need to put this money to work somehow, somewhere.

I would suggest you take a look at the following in descending order:

  1. Create an emergency fund equivalent to 6 months of your expenses, and store these funds in a high yield checking/savings account.
  2. Boost your 401k, 403b, TSP retirement contribution to get 100% of your employer match.
  3. Aggressively pay down high interest debt. This keeps the amount of interest (e.g. profits) paid to your creditors to a minimum.
  4. Open, or max out, your Roth IRA.
  5. Consider opening a brokerage account focusing on low cost, broad market index funds and ETFs.

Please note, each person’s situation will vary. So if you have a big ticket item that you’re saving up for (car, medical expenses, credit card debt repayment, etc.), then you would might want to focus more on building savings and aggressively paying down debt instead of investing.

What to Do if Cash Flow Negative?

If you’re cash flow negative, you need to right the ship as quickly as possible. After all, if you’re spending more money than your making, you can only keep your head above water for so long until someone bails you out… or you sink.

I would suggest you consider the following long term fixes:

  1. Try to reduce your standard of living. If you’re eating out 4 times a week, learn how to cook restaurant like meals half the price. Learn how to use bargain hunting websites like Craigslist and eBay that offer tremendous cost savings. Depending on how much of a bargain hunter you are, or how bad your cash flow situation is, you might even develop a preference for used stuff since you can save quite a bit by buying secondhand versus paying retail prices.
  2. Consider selling some of your assets. If feasible, consider liquidating those high cost items that are wreaking havoc with your monthly budget. If you’re paying $600 for an auto loan, when you can only afford $300, it might be time to trade down to a better value.
  3. Earn more! Instead of playing defense, go on the attack! The cash flow equation is composed of two distinct variables, and if you can boost your income, whether that be a second job, getting a roommate to pay half your bills, or starting a small business in your spare time, it will definitely improve your cash flow situation. I ran into this problem after entering the work force, where I acquired too many assets, had a very high debt to income ratio, and essentially, became a slave to my stuff.
  4. Adopt a frugal living lifestyle. Learn to be a bargain hunter, and only buy those items that you need versus want. I’m something of a frugal living and anticonsumerism advocate, and so here are a few of my favorite frugal living substitutions from 2009 that you might want to try.
  5. Use the Internet to cut out the middleman. One of the interesting features about the Internet is that has a disintermediation affect, and it’s beginning to cut out the middleman mark ups by linking buyers with manufacturers. For example, instead of keeping your traditional landline that costs $50+ per month, disconnect it and switch to MagicJack that costs $20 per year. If you’re cable TV is too expensive, renegotiate a better rate (excellent step by step instructions here and here). If you live in a major metro area with lots of small businesses bending over backwards for customers, learn how to use social media bargain hunting sites where half off deals and coupons are targeted specifically for your area.

I hope that gives you some insight into where you stand. Either way, regardless of whether you’re cash flow positive or cash flow negative, chances are fairly high you’ll improve your situation by simply knowing this most basic of personal finance metrics. If you’re in the red, you’ll want to right the ship. If you’re in the black, you’ll want to cut costs and/or boost your income.

As always, if you have questions or need assistance in calculating your cash flow statement, just leave a comment or use the contact me page and we’ll get you on the right track.

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Posted by CJ   @   5 February 2010 9 comments
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9 Comments

Comments
Feb 6, 2010
12:14 pm

Thanks for linking to my Comcast suggestions! Awesome post.

Feb 6, 2010
1:58 pm
#2 Matt SF :

No problem. Was a good post and hopefully will inspire others to do the same.

Feb 8, 2010
1:08 pm

Great post – you can’t spell it out more clearly than that. Loads of resources and nice of you to share your personal experiences of over-consumption too.

Feb 8, 2010
2:31 pm
#4 Matt SF :

Thanks HA. I think some of the best, and perhaps personal, posts come from those individuals who found themselves knee deep (or deeper) in a situation and managed to dig themselves out. Somehow, that personal touch gives it that something extra.

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