When it comes to financial planning, managing your household cash flow is an incredibly important skill. To be able to manage your cash flow, you need to first gain an understanding of your household cash in-flows and out-flows. Contrary to our competitive nature as Aussies the real value of understanding your household cash flow is not to see who can spend the most money on beer each month, but to facilitate rational decision making across 3 key cash flow management areas in order to improve your chances of achieving your goals (financial or otherwise). The areas that I will talk about in this article about are:
- Increasing income
- Funds allocation
- Optimizing spending
If you’re a picture person, like myself, here’s an illustration that describes the real value of tracking your household cash flow:
How to track cash flow?
In the FFE house, we fill out this budget spreadsheet every couple of months, this gives us a snapshot of how much money is coming in as well as how much we’ve spent in a variety of areas such as groceries, eating out, phone bills etc. Since almost all of our spending is via credit cards this places the majority of information in a small number of online locations which makes the recording process very straight forward. If you are able to sensibly spend money on your credit card, I’d recommend this method for recording expenses.
If you are new to recording your expenses, I’d recommend doing this for a few months while spending as you normally would in order to create an accurate baseline for your household spending habits.
What to do with the information?
Once you have the information on household cash in and out-flows you can then understand what your excess cash flow looks like which will allow you to determine if your goals are achievable. From this point you can make decisions around how you want to focus your energy across the 3 areas outlined above.
Increasing income
Working on increasing income is especially important for households that are lower on the income scale, this is because there is a limit to how far you can cut your expenses however there is theoretically no ceiling to increasing income. Another scenario could be one where a household may be earning a good income but still have insufficient excess cash flow to meet their goals and they do not think that they are able to reduce their expenses. In both cases, understanding of a household’s cash flow situation will likely lead to a decision to focus heavily on increasing income.
Prioritization of funds
The majority of goals require some sort of financial commitment, further to this, a household will often be working towards a savings goal as well as a spending goal at the same time. An example of this would be paying off a mortgage and wanting to buy a boat. An understanding of how much excess cash flow your household has allows you to know if your goals are achievable. You can then prioritize funds in such a way that will allow you to achieve those goals or alternatively you may choose to modify your goals. For example, in the FFE household 2 of our key goals each year are to add money to our investment portfolio and to travel overseas. Our understanding of our cash flow situation allows us to prioritize money each month towards these key areas so that we have the best chance of achieving both goals simultaneously.
This focus area is also important for forecasting savings targets for upcoming large expenses. For example, if you want to purchase a $50,000 car in 5 years’ time you will need to allocate funds toward the cost of its purchase. Understanding your budget will facilitate decision making on how the funds are prioritized. Can you save $10,000 each year over 5 years? Or will your budget mean that you need to save $30,000 this year because you can only allocate $5,000 over the next 4 years? Should the money come from your portfolio or should you allocate a separate account to hold the money? Should you lease the vehicle? These are all questions that understanding your cash flow will help you to answer, because when it comes to personal finance you not only need to look at the individual parts but the situation as a whole because ultimately all decisions will affect the path that you take to achieving your goals.
Controlling expenses
I can’t stress enough the importance of being able to control your expenses. While there is no limit on earning, there is also no limit on spending. Understanding cash out-flows will allow you to see how much various categories of expenditure are costing your household. This will facilitate decision making around where you allocate your energy towards controlling/reduce expenses. When looking at spending areas the key questions you need to ask yourself, and your partner, are:
- Does spending this much money in this area bring us happiness?
- Is there a way to optimize the amount of money spent this particular area?
For a lot of the areas you’ll likely be surprised as to how much money is spent. When you really consider how much value that spending brings to your life this will give you pause to consider ways that it can optimized. Remember, the primary objective is not to make sacrifices but to reduce wastage i.e. spending that does not bring value to your life. For example, 2 beers on a Friday night will probably provide an excellent amount of happiness and satisfaction but 15 beers will likely bring you some level of dissatisfaction on Saturday morning. I would argue that cutting out the 12 beers would simultaneously decrease spending while increasing overall happiness, but each to their own I suppose.
In summary
So, to summarize this post in 1 sentence, the real value of tracking your household cash flow is to facilitate decision making in order to achieve your financial goals.
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