Understanding Cash Flow is Critical

The real poverty of typical families is found neither in their low income nor on costly essential expenses, but rather in not understanding their own cash flow.

Regardless of income level, overspending causes poverty. Saving and budgeting produce wealth.

A person may be making millions and live on a large ocean-side estate, but can be driven into bankruptcy from poor cash flow under the weight of costly mortgage payments, lawn and pool maintenance, luxury cars, and extravagant vacations.

Cash flow is the net movement of money for a given entity. Annual cash flow of the typical household is all the family’s income minus all the family’s expenses.

If the net cash flow is negative, the household ran a deficit for the year. One year of deficit means many years of debt. With interest payments, it frequently leads to financial defeat.

If net flow is positive, the household ran a surplus. One year of surplus means many years of investable savings that, with market growth, frequently leads to financial success.

Financial wins and losses happen this easily: Did you save and invest more of your income than you spent?

This logic and method of calculation applies to any entity, be it private or public, corporate or familial. Cash-flow issues cause corporations to sink or swim, households to go bankrupt or pass on a substantial inheritance, and governments to inflate the currency or provide a safe storage of value.

Although the business world handles the idea of cash flow fairly well, both the federal government and most households sorely lack this knowledge.

Many families don’t know what their income is, few keep a budget, and even fewer know how much they spend in a year. 

This is particularly sad because budgets are how we allocate our income to the things we value. Without a budget, either every purchase is a chore or you’re vulnerable to excessive spending. If like the federal government you don’t stick with the budget, you are just as bad off as if you didn’t have a budget in the first place.

Going into debt by purchasing items you didn’t want as much as the price you paid for them is a common financial mistake. At Christmastime, economists call it a deadweight loss when gift-givers pay more than the recipient of the gift would have paid. A similar loss occurs when people spend without or outside of a budget.

A budget is your chance to cut deadweight loss out of your life.

It’s all about cash flow. Choose the goal of living a fulfilled life rather than the highest income. The low income of a struggling poet is likely well below the poverty line. But with a simple life and few expenses outside of basic needs, you could manage just fine. Cutting out costly automated expenses — like your cable and Internet bills, phone plan and car payments — is a great beginning. Negotiate a better rate, downsize the plan, or cut the expense entirely.

If a low-income profession equates to a rewarding life, then live that life.

If you’re new to analyzing your cash flow, tax returns fortunately require you to calculate your income annually. Then you can determine what your monthly income has been historically, even if it is not consistently paid to you.

Artists, real-estate agents, independent contractors, and other similar professionals often find it challenging to determine their income because of variable and erratic payments. To manage your cash flow wisely even when your income is inconsistent, strive to smooth your standard of living. Determine from your records what income you believe is dependable and guaranteed, and set your savings and budget based on that amount.

In economics, the cost of an activity is the highest-valued opportunity foregone. Sometimes the cost of impulse purchases is the failure to meet long-term financial goals.

Almost every American family can save 15 percent of its income and would benefit from this practice. For a family of four at the poverty level, this would mean saving $300 a month. It only takes saving and investing $100 a month from age 20 to 65 to reach a million dollars at retirement.

On the withholding of Social Security (12.4 percent) and Medicare (1.45 percent) from our paychecks alone, we should all be retiring as millionaires.

In whatever realm you control, whether it is a nonprofit, corporation, governmental agency, or your own household, insist on a detailed review of your cash flow. Sitting on a board or managing a department and not reviewing your cash flow carefully is a breach of fiduciary duty. Catalog your expenses, assess your income, and set a budget that you or your organization can use to optimize living within your means to meet your most important goals.

Cash flow, income, and expenses provide the key to financial responsibility. It is the difference between future happiness and future misery. The decisions we make today — to run a surplus or a deficit — impact ourselves and the institutions we manage long after we’ve forgotten what we did that year. The deficit years of our past create the financial emergencies of our present. Meanwhile, years of plenty and surplus create smooth sailing for the unknowns of the future.       

David John Marotta is president of Marotta Wealth Management, Inc., which provides fee-only financial planning and wealth management at www.emarotta.com. Megan Russell studied cognitive science at the University of Virginia and now specializes in explaining the complexities of economics and finance at www.marottaonmoney.com