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The Importance Of Cash Flow

Cash flow is clearly one area where avoidance is a bad idea. Whether you are running a business or managing the household finances, cash flow is critical. Read more...

Whether you are running a business or managing the household finances, cash flow is critical. The difference between cash coming in and cash going out in any given period of time is the net cash flow. If it is positive, your cash balances will increase and if it is negative, your cash balances will decrease.

The easiest way to grasp the concept of cash flow is to think of a water tank. Imagine a pipe at the top of the tank pipe bringing water in from an external water supply. At the bottom of the tank, imagine a pipe taking out water to be used for a multitude of purposes. The water in the tank will rise and fall depending on whether more water is coming in than going out.

Cash flow is easy to manage when the flows are constant. It is not so easy where there is large variation in cash flows, for example in small or expanding businesses, in households where income comes from self-employment or from commission, and in property investment. Without careful management the tank can run dry, with disastrous consequences.

The principal tool for managing cash flow is planning. With a cash flow forecast, that is a month-by-month analysis of estimated money coming in and money going out, you can estimate the net cash flow and the impact this has on cash balances. You can then put strategies in place to cover the periods when there is likely to be a large negative cash flow – for example, altering the timing of payments, borrowing funds, finding additional sources of income or cutting down on expenses. Many businesses, property investors and households have grieved when the tank runs dry and there is no contingency in place. Don’t be one of them!

The point is the choices you make heavily impact the amount of your paycheck.

What is cash flow?

Cash flow is basically the in and out motion of money. Those who simply earn income and pay bills are not engaged in the process of cash flow management. Real cash flow management involves understanding the components that make up where the money comes from, where it goes, and what choices are appropriate in creating a life of greater satisfaction. You should be tracking this either weekly, monthly or quarterly.

There are two kinds of cash flows:

Positive cash flow: This occurs when the cash funneling into your business from sales, accounts receivable, etc. is more than the amount of the cash leaving your businesses through accounts payable, monthly expenses, salaries, etc.

Negative cash flow: This occurs when your outflow of cash is greater than your incoming cash. This generally spells trouble for a business, but there are steps you can take to remedy the situation and generate or collect more cash while maintaining or cutting expenses.

Achieving a positive cash flow does not come by chance; you have to work at it. You need to analyze and manage your cash flow to effectively control the inflow and outflow of cash.  Cash flow analysis is necessary to make sure you have enough cash each month to cover your obligations in the next month. Managing cash flow includes:

1. Components of income: 

Income can be derived from salary, bonus, hourly, self-employed, passive or investment sources. In some cases, you can control your income, i.e. working longer hours or a second job, taking on additional clients, or choosing investments that provide higher levels of income. In most cases, control is limited.

2. Fixed (structural) expenses:

These are foundational costs over which you have little monthly control. For example, rent, mortgage, and utilities; the bills come in every month and while you might move to a slightly cheaper apartment, or get a cheaper car, without structural changes, this category is locked in. A structural change might mean moving to an area where property costs are less or moving into a smaller home.

3. Discretionary expenses:

These are expenses where you can exert more control. For example, you can shop at discount stores rather than premium name brand stores. You can choose whether to invest your vacation on a trip to Europe or a less costly domestic adventure in Nigeria. The point is the choices you make heavily impact the amount of your paycheck.

4. Taxes: 

This is the category that makes us most uncomfortable and, for most people, an automatic deduction. If you either owed the government a substantial balance or received a significant refund, you have some work to do on the tax segment of your cash flow management. If you are self-employed, tax management is an even more critical aspect of planning.

5. Savings:

Savings is the last component in the cash flow puzzle. Do you save regularly and systematically or do you save when there’s something left over? Savings is our opportunity to capture and secure our wealth. The better choices you make in the other categories, the more wealth and security derived.

Imagine the increase in your life and money satisfaction when you feel in control of your spending and especially your savings. Possessing the power and knowledge of how well you have increased the velocity of your savings and thereby your wealth-building creates options, alternatives and more life choices.

 

Have you started managing your cash flow? What has the experience been like? Let us know in the comments.