In my opinion, sound investing is a must for everyone, but it should not be at the expense of your cash flow. What is cash flow then? Simply put, cash flow is the moving in and moving out of money. For most of us, the moving in of money comes from salary and the moving out of money comes in the form of bills and household expenses. But is earning a stable salary and paying bills on time considered “proper Cash Flow Management”? The answer is NO!
Understanding Cash Flow Management
To understand Cash Flow Management, we can divide the subject into five components: 1.) Sources of Income, 2.) Fixed Expenses, 3.) Discretionary Expenses, 4.) Anticipated Expenses and 5.) Emergency Expenses.
Income, as defined by Merriam-Webster, is money that is earned from work, investments, business, etc. As the definition suggests, income may come in several forms, the most reliable form of which is salary. Other forms of income are business income, professional fees and gains from disposing an asset (i.e. financial securities, real estate, etc.). Income from salary is very easy to manage since the Philippine Labor Law requires at least two (2) periodic payments per month, thus we can easily match anticipated expenses. Other sources of income may be variable in nature, thus managing it takes careful planning since there is an aspect of uncertainty as to when and how much we can get.
Expenses may be fixed or periodic in nature. Fixed or periodic expenses commonly take the form of bill payments such as utilities, telecommunications expense, rent, mortgage/loan payments and the likes. The nature of these expenses are pretty much defined on the onset and will continue to accrue until such time it is discontinued or fully paid for (in the case of mortgage and loan payments). Understanding the nature of this type of expense allows us plan our finances on the onset since the payment period and amount, to some extent, is pretty much determinable.
Some expenses are incurred due to the discretion, or by choice, of a person. These types of expenses are often time “non-essential” to address the basic need of survival. Common examples of this type of expense are vacations, luxury goods, premium coffee and even down to simple choices such as taking a cab rather than mass transit or opting to eat out rather than cooking at home and etc. Since these expenses are non-recurring (in most cases) and non-essential, this is an area where we can exercise flexibility in the management of our cash flows.
Anticipated expenses are future expenses that a person is aware of and would like to plan for it now. Examples of this type of expense arethe cost of insurance coverage (both life and non-life), memorial plan, car purchase, home mortgage, education and the likes. These expenses are usually big-ticket purchases that may not be affordable to a person now, thus requiring them to build-up savings first before availing or to purchase it and pay for it in regular intervals. Since this type of expense is foreseen on the onset, a person may plan ahead of time on how to finance the purchase. The budgeting method is similar to planning for fixed expenses; the difference is that the benefit is enjoyed on a later date rather than now.
Emergency expenses are expenses that are unexpected and often require immediate attention. Examples of this expense are hospitalization, death of a loved one, replacement shelter (rent or purchase), replacement of a necessary asset (i.e. mobile phone, car, clothing and gadgets, in the event of a disastrous loss) and other similar urgent concerns. Since these expenses are pretty much unforeseen, planning for how much to set aside is quite tricky since the cost may be low or high. As such, planning for these expenses requires build up during good days and setting it aside in the form of savings or investments in very liquid and relatively low risk assets. These provisions are called Emergency Funds, which will be discussed later in this article.
Matching Cash Inflows and Outflows
Having knowledge of the different nature of income sources and expenses above, we can now plan our finances more effectively. As a general rule, recurring income must be used to cover recurring expenses. Since fixed expenses are usually essential to survival, we should first secure these know expenses with our most stable source of income – Salary or Business Income, with preference to the first, if any.
As far as compensation income is concerned, recurring income may also come in the form of monetary benefits such as allowances, statutory bonuses, guaranteed bonuses and monetary benefits stipulated in the employment contract. As long as the amounts of these monetary benefits are pretty much determined and guaranteed to be given on a specific date or fixed number of times during the year, you can use them as a cash inflow to address fixed and foreseen expenses.
Managing Discretionary Expenses
As a general rule, we should finance discretionary expenses only with income in excess of the amount required to pay for fixed expenses and amount set aside for anticipated expenses. To determine how much you can spend for discretionary income, one has to define their cash outflows for a pre-determined period (semi-annual or annual). After scheduling expenses, net it out with expected cash flows from all sources that are guaranteed to be received, or the likelihood of receipt is almost certain. The difference is what we call our budgeted savings, which will serve as your guide on how much you can spend for discretionary expenses. As a general rule, discretionary expenses should not exceed your fixed and anticipated income. A breach of that rule may result into the erosion of your savings, force you to take an interest-bearing loan or force you to miss on some payments.
The Emergency Fund
The future is never certain, and as such, we are vulnerable to any changes in our financial circumstance. A sudden big expense might derail our financial plan unless we amply prepare for it. To address this risk, we need to set aside an emergency fund that will be exclusively used for such events. The emergency fund are accumulated savings, targeted to reach a fixed amount or continuous accumulation, that are set aside to be used in emergencies such as loss of a job, illness or other major expenses arising out of contingencies. The fund’s purpose is to secure a person’s finances by proving them a safety net against any contingent expenses. As a general rule, a person must set aside an emergency fund that can cover expenses for at least 6 months.
Maximizing Potential and Happiness
Most Filipinos with low financial literacy are at the mercy of their paycheck, spending energy and time on non-value adding activities such as worrying on how to go on from one paycheck to another. With proper cash flow management, we can be more in control of our finances, allowing us more time to spend on developing our potentials and maximizing happiness rather than worrying about how to bridge income and expenses.
~ By Bear Abad