Understanding Your Personal Cash Flow
Comprehensive cash flow planning has been one of my core expertise in what I do for my clients professionally. For the most part, I enjoy crafting out a plan for the future. By the same token, I am also a consumer who is stepping into a world filled with unknown variables. With this in mind, I am aware on the importance to conduct a comprehensive cash flow planning for both my clients and myself.
- Part 1: Income (Active Income, Passive Income)
- Part 2: Expenditure (Fixed Expense, Variable Expense)
- Part 3: Net Cash Flow (Surplus, Deficit)
- Part 4: Basic Financial Ratio (Rainy Day Funds, Savings Ratio, Debt Management Ratio)
Part 1: Active Income
Active Income is money received in exchange for providing a service. For example, I work as a private-hire driver and my job is to drive a passenger to his intended destination. In return, I get paid a fare.
On the other hand, I will not be paid if I do not drive the passenger to his destination, i.e. active income stops when I stop working.
Passive Income is money received on a consistent basis with minimal effort to generate the revenue. For instance, I rent my car to a private-hire driver (instead of driving the car myself).
Regardless of whether there is a passenger, I will still receive a rental income.
Total Income = Active Income + Passive Income
Altogether, total income determines my earning ability in a month. For most of us, we focus on active income through active employment, i.e. no work = no pay.
At the same time, it is useful to understand the value of passive income (I will elaborate more later).
Part 2: Fixed Expense
Fixed Expense is the same cost that I will spend every month regardless of the situation. For instance, insurance premium is a fixed expense because I cannot vary the amount over time.
Variable Expense is a cost that changes according to my spending habit. For instance, food and transport are variable expenses because I can choose what to eat (hawker vs fine dining) or how I commute (MRT vs taxi).
Total Expenditure = Fixed Expense + Variable Expense
Altogether, total expenditure accounts for my cash outflow every month. For most of us, it is important to keep our fixed expenses as low as possible. Otherwise, we will always lose a huge chunk of money whenever we receive our salary. 💸
Part 3: Net Cash Flow
Net Cash Flow = Total Income – Total Expenditure
At the end of the month, we should always strive to achieve a positive net cash flow, i.e. a monthly surplus, or a situation when our total income is more than our total expenditure. Once we managed to create a simple cash flow statement, there are 3 basic financial ratio that gives us an overview on our financial health.
Part 4: Rainy Day Funds
As a general guideline, keep 3 to 6 months of our total monthly expenditure in the bank.
What happens when We have less than 3 months of rainy day funds
Either increase our income or reduce our total expenditure. By doing so, we will increase our net cash flow. Accordingly, we will continue to build up our rainy day funds with the additional monthly surplus.
What happens when We have more than 6 months of rainy day funds
It is good to have sufficient liquidity. However, every dollar in the bank is eroded by inflation every year. With excess rainy day funds, we are hurting our own financial health in the long run – imagine $1million today is worth less than $700k after a decade! 😢
In truth, this is nothing more than a false sense of security when we could be better off spending that money than to watch it “disappear” over time.
Savings Ratio = Monthly Surplus / Take-Home Income
As a general guideline, save at least 10% of our monthly take-home income for our future. With the savings, build up our rainy day funds. While doing so, we should also start planning for our future.
Usually, I prefer to start by planning for the furthest goal, i.e. my own retirement. This is simply because of the power on compounding – doing less (using little money) with more (time).
💡Pro Tip: Always pay yourself first. This is easily done by setting up a standing instruction and transfer a portion of your salary to your savings account on your payday. Ultimately, we worked hard for the money. Therefore, it is only right for us to pay ourselves first.
Debt Management Ratio
Debt Management Ratio = Total Loan Repayment / Take-Home Income
As a general guideline, we should aim to have a ratio of less than 35%.
This is because loan repayment is a fixed expense. Consequently, we will always have to pay it regardless of the situation. By keeping this ratio low, it ensures that we are prepared for any unforeseen situations, e.g. loss of job.
When such situations occur, we will have to rely on our rainy day funds and the last thing is to exhaust this fund too quickly. At the same time, what if the salary of the next job is lower? Then this will definitely hurt our net cash flow further.
Conclusion on Cash Flow
Understanding your own cash flow is more important than knowing how to earn money. At the end of the day, it is what you keep that matters (i.e. monthly surplus from a positive net cash flow). To be fair, I have come across cases when a lower-income earner saves more than a high-income earner.
In any case, strive to create a passive stream of income for yourself. When your passive income is more than your total expenditure, you are on the right track to reaching financial freedom.
Meanwhile, do a comprehensive cash flow check on yourself (as the above is a simple introduction) to ensure that you have a good financial health. At the same time, consider speaking to a professional or someone who you trust for an independent advice or opinion.
If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle. – Sun Tzu, The Art of War
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