A budget will show if your expenses are on track but your cash flow shows how quickly you’ll reach financial independence.
What does cash flow have to do with my FIRE (Financial Independence, Retire Early) planning?
Your net worth gives you a good snapshot of what your current financial life is like. Think of it as a photo of that particular moment in time. Well, your cash flow statement will show you what is coming in and what is going out of your bank account over a period of time. Most people will find it most beneficial to do this on a monthly basis, so that’s how I’ll refer to it from now on. Your cash flow number can be positive (more money coming in than going out, yay!) or negative (more money going out than coming in). The former is perfect, the latter is deadly; it can’t be sustained for very long without crippling your net worth, and your net worth is the driving force to realizing financial freedom!
Budget, cash flow, what’s the difference?
A budget tells you how much you can spend in each expense category for the month; it has nothing to do with income. It tracks every expense into each category and takes a lot of time to keep up with throughout the month.
Meanwhile, a cash flow statement takes income into account so it can tell you quickly if you are spending too much money each month. It also doesn’t get bogged down with spending $100 too much in one category and saving $75 in another line item. It’s easier to keep tabs on month-to-month since you look at overall spending.
With that said – If your cash flow is negative you definitely want to get into the details of your budget and figure out where the extra spending is taking place. More on that later.
Step 1: find your BIG.
Your BIG is how much you need to survive each month. Combine all of your fixed expenses, debt payments, discretionary spending, etc, and that should be the amount of money you need each month in order to pay all of your expenses. That’s your BIG (as in the one big expense number you need to remember). We’re not trying to cut expenses during this step; it should be a real reflection of what you are actually spending each month. If your monthly income is greater than your BIG, you are on the right path. If it’s less, you need to do some soul searching (and expense cutting).
It’s very important to know your BIG. It’s one of the main factors in determining all of your other retirement calculations.
Step 2: add up your income.
This one should be a little more fun: think of every way you currently make money and add them together. Most likely, this includes w2 income from a regular job. It may also include interest and dividends from an after-tax brokerage account, any positive cash flow from a rental property, cash from your dog-walking side hustle, or some 1099 work you do as a consultant a few times a year.
I like to use the take-home pay number for w2 income rather than the gross income amount. Yes, your 401k contribution goes towards your savings and net worth, but I don’t want you thinking you could cut that to get your cash flow positive. So get that out of your head now and don’t even begin including it.
For inconsistent income, use the average for the monthly amount. If your consulting brings in $1,000 in April and $3,000 in September, that would average $333 a month in income ($4,000 / 12 months = $333.33). Or you can completely leave it out if it’s really not a reliable source of income.
Ok, so you have all of your income written down in front of you. Now it’s time for…
Step 3: BIG, meet income.
Step 3 is super easy, I promise – take your total income figure and then subtract your BIG from it. That’s it. If you have a positive cash flow number, you’ve cleared the first hurdle and can focus on accelerating FIRE through fine-tuning and optimizing (like making your BIG number smaller!).
Remember, cash flow is the driving force of net worth, and net worth is the driving force to financial independence.
Everything else rests on this one concept, so if your cash flow is negative please keep reading.
With negative cash flow, you need to find ways right now (RIGHT NOW!) to get to positive. Trim expenses, get a side hustle, call insurance companies and switch, lower your cable bill, ask for a raise, do whatever it takes to get your cash flow positive.
Bad cash flow means you need a good budget.
It’s a good idea for you to do a detailed budget to get into the nitty-gritty. (Do it once, make meaningful change, and then you can be right back on track following cash flow!). The best way to start figuring out your budget is with google to find a template already made. I think actually printing out a worksheet and putting pen to paper helps in this initial step. A few good worksheets I found: FTC, Freddiemac, and Financial Avenue. If you’re technically savvy, though, I’m sure you can find an online spreadsheet or even build your own in Excel or Google Docs. You could also use an app like Mint or Personal Capital.
Start filling in each item listed and remember to think of all of it on a monthly basis. This is the amount spent each month, not your balance (the balance goes on your net worth statement). For instance, let’s say you carry a credit card balance (Shame!) of $13,000 and pay $2,000 a month towards it. Guess which amount goes where? The $13,000 should be on your net worth statement (with a minus sign in front of it, Shame!), and the $2,000 figure should go right here on your budget. Continue filling in everything until you have your final amount.
What about stuff you don’t pay each month?
Items that will trip people up are the expenses only paid once or twice a year. How do they fit into your monthly budget? I personally have a separate bank account set up for each of those items with Capital One so I don’t include them in my monthly budget. For most people, though, it makes sense to divide the total amount by the number of months. Pay your home insurance once a year? Divide it by twelve, and know you need to put that amount aside each month. Pay your car insurance every six months? Divide by six. Same deal here: put that amount aside each month.
Don’t forget the expenses on the horizon.
Also think about future expenses that aren’t occurring now. An example could be that your car is fully paid for now, but it’s about to die… you need to start accounting for the future expense of a car purchase. Starting to budget for it before it happens will put you way ahead of the game. Another example: you want to take the family on a vacation, but your vacation envelope is empty… it’s much better to start putting money aside for it now rather than put it all on a credit card and be a slave to the debt after the vacay; there’s no better way to ruin that post-vacation feeling than seeing the next credit card bill.
How does your detailed budget look?
At this point, you’ve filled out the budget worksheet completely. All of your expenses laid out in front of you. Take time and figure out what you can realistically cut from the budget. Don’t say I’m going to cut out coffee if that’s a huge part of your morning routine. Instead, figure out how to get your coffee cheaply each day. I buy coffee from Costco for about 30 cents a cup; far different than $4 a day at Starbucks. You don’t need Disney+, Apple+, HBO Now, and Showtime Anytime all at the same time… rotate them. Watch everything you want to watch on one of the services, then cancel it and go to the next. Make decisions like that for everything on your budget. Don’t skip over the big three, either: housing, transportation, and food. Can you move into a cheaper apartment in the same area? Can you lower your car payments by trading in for a used, reliable car? It might hurt to make these decisions, but just remember that it’s temporary. Once you are on much better financial ground you can reevaluate. (and at that point, the financially smarter future you might decide that it was stupid to have it before in the first place.)
A negative net worth is not the end of the world, but negative cash flow could be!
To reiterate that point:
As long as you have positive cash flow you will be chipping away at that negative net worth every month. Before you know it, your net worth will be positive and then there’s no looking back!