What is Cash Flow?
To understand the the importance of cash flow we must first understand what cash flow is. Cash flow is the total amount of money being brought in and out. Cash flow is the life-blood of a business but what about your personal finances?
We tend to think of cash flow as something that only businesses or governments contend with, but it is integral to our personal financial lives as well. Cash flow enables us to do what we want, and to help achieve our goals or objectives. These goals could be paying off the mortgage, saving for college, taking a vacation, and of course, saving and investing for retirement.
We’re all familiar with the phrase “cash is king.” Don’t get me wrong, cash is great, because it’s liquid and accessible. It’s like a refreshing pint of beer. But, once you drink all the beer, you are left with an empty glass. It’s the same with cash. When it’s spent, it’s gone. Cash flow, on the other hand, is like a beer fountain. There is a constant stream of beer you can drink, or use to refill your glass, whenever you want.
Now hopefully I didn’t make you thirsty! In essence what I am saying is with the right strategy, your savings and investments will generate consistent cash flow.
Don’t get cash flow confused with a budget. Cash flow simply determines how much income you have left over after all of your fixed and variable expenses. Once you know if you have a positive or negative cash flow. You can develop a budget.
Where does Cash Flow start?
Cash flows starts in our working years. It comes from our salaries through our employer or profits from a business. When we’re retired, ideally, we have accumulated enough money in our retirement accounts. The strategy is then to turn those assets into a reliable retirement stream of cash flow. Remember, the main objective to saving and investing is to eventually convert it into cash flow.
Wall Street teaches us to focus on the rate of return on our investments. However, we should instead focus on cash flow. Why? Because you can’t spend rate of return. For example, if you have invested in growth stocks in the stock market, where the goal is appreciation. In order to create “cash flow” from those growth stocks, you will need to sell shares. If the stock market goes up enough, you can simply sell enough shares to generate your retirement income.
However, what happens when the stock market goes down? You have no positive rate of return. Therefore, you must sell shares at a lower value or perhaps at a loss. This is not ideal and hopefully doesn’t happen for an extended period of time.
If instead, you saved or invested in something that generates cash flow such as dividend stocks, interest generating investments, etc. That cash flow is usually more reliable and you won’t have to rely on a positive stock market in order to sell shares for your retirement cash flow needs.
Importance of Cash Flow
Cash flow is important whether you are in the accumulation phase of your life (while you are working) or in the distribution phase (in retirement). But the thought process behind how you use this cash flow is different in each phase.
For example, if you’re in the accumulation phase, you’re likely to reinvest the dividends or interest to build up your account value. You are probably more risk tolerant as well – investing in higher risk, higher reward investments.
In addition, you will likely make or have already made mistakes. Don’ worry, we all do. Live and learn – always moving forward! Hopefully you will or have learned from those mistakes and will or have improved upon your accumulation plan. Then, once you get to retirement, you’re likely to have the dividends, interest, etc. paid out to generate cash flow to support your lifestyle in retirement.
Cash Flow Sources
I’m a big believer in building up tax-free and tax-deferred cash flow sources. We’ve been taught to put away as much money as we can during our working years into pre-tax retirement accounts such as our 401(k)’s. Or, post-tax retirement accounts such as Roth IRAs. The assumption is that when we retire, we’ll be in a lower tax bracket but everyone’s situation is different.
Just be aware that if you’re deferring income now into tax-deferred retirement accounts. You might find yourself paying taxes on that income at a much higher tax rate later on when you withdraw it.
Some ideas to consider:
- If you can contribute to a 401(k), contribute up to the company match but you don’t need to exceed the match percent.
- Look to make Roth IRA (or Roth 401(k), if available) contributions, which are taxed now but tax-free when withdrawn.
- Diversify your retirement holdings with dividend paying stocks to start generating cash flow that can be reinvested now and later be distributed for monthly income
- Buy permanent life insurance, which accumulates cash value that can be accessed tax-free (via withdrawals up to basis and/or policy loans).
- Consider alternative investments, such as real estate. These generally provide cash flow and are also less correlated to the stock market.
As Robert Kiyosaki said, “The most important word in the world of money is cash flow.” Now that you have discovered the importance of cash flow, how do you calculate it? If excel spreadsheets are your thing, you can find plenty free one online. However, if you’re like me, I like to automate! Personal Capital provides cash flow analysis for free.
If you’re an avid reader, you know how I preach automation and Personal Capital provides a free tool to aggregate all your data. From the dashboard you can see your net worth and even create a budget.