There’s more to tracking your finances than understanding your net worth and having an effective personal budget in place. It’s also critical to keep a close eye on your cash flow. What’s is cash flow exactly? Let me first delve into the 3 types of financial statements including the cash flow statement, and then I’ll go into the importance of maintaining a solid positive cash flow.
3 Types of Financial Statements
Businesses have three different types of financial statements: a balance sheet, an income statement, and a cash flow statement. Most people don’t realize that these same statements also directly apply to their personal finances, even if they don’t have their finances labeled as such. Let’s briefly look at each of these statements:
Your balance sheet can help you calculate your net worth. It details your assets and liabilities. Your assets might include the equity in your home, investments, and cash in the bank. Liabilities might include the amount owed on your mortgage, your vehicles, or your credit cards. Obviously, the aim is for the asset side of your balance sheet to be much larger than the liability side. After subtracting out your liabilities from your assets, you’re left with what is known as your owner’s equity. This is what you would have if you liquidated all of your assets and paid off all of your liabilities in full. If this number is negative, you need to reevaluate things!
Your income statement can tell you how much money is coming in and how much is going out over a given period of time. You can track this monthly, quarterly, or annually, but ideally you’d want to track all three. An income statements shows much money is coming in from your pay check, investments, or business, and how much you will spend on debt servicing, maintenance, insurance, savings, and other expenses. After subtracting your expenses from your revenue, you’re left with your income or profit. Your budget should be designed so that your income is high enough to support your living needs.
Income statements reflect the income earned over a specific period of time, while balance sheets are all-encompassing in that they are a snapshot at any one moment of an entire company’s or individual’s assets and liabilities. An improving income statement will lead to an improving balance sheet due to increased assets.
Cash Flow Statement
The cash flow statement also looks at income and expenses, but is more concerned with how and, more importantly, when the money is entering and exiting your accounts. As anyone who runs a business will tell you, money is great on paper, but it ultimately comes down to the timing of your revenue and expenses.
Why Cash Flow Matters
Imagine a company that has $20 million in assets and $15 million in liabilities. Moreover, its most recent income statement shows that revenues exceeded expenses by a nice margin of $5 million in the last quarter. So the balance sheet and income statement are solid.
Now, let’s suppose this company is looking to expand and plans to spend $5 million during each of the next three quarters on capital expenditures. It plans to finance these expenditures using the company’s projected $5 million in quarterly income for the next three quarters. This seems like it should work fine, right? But, what if some of their largest orders fell through, or their customers were late paying? Or what if the company allows their customers 60 days to make their payments, but the company only has 30 days to make the payments on their capital expenditures? This would eventually lead to what is known as a cash flow crunch, and eventually the company would be “in the red.”
These are the types of situations that can cause a seemingly healthy business to fail spectacularly. Sometimes timing is everything. The same is true in personal finance. You may be counting on a big raise, a large commission check, or simply your weekly paycheck, and decide to purchase some extras with the understanding that you’ll be able to pay off your credit card by the time the bill comes due.
If everything doesn’t proceed according to plan – and it’s kind of amazing how often that actually happens – you could be left with a cash flow problem that can either cost you a ton in finance charges or potentially cause you to go bankrupt.
So how we do avoid this problem? Let’s take a look at some ways to prevent ever having to deal with a cash flow crunch.
How to Avoid a Cash Flow Crunch
There are a few steps you can take when you’re setting up your budget to avoid a cash flow crunch:
- Identify Expenses That Have the Potential to Cause Cash Flow Problems: These would typically be larger expenses that are often paid in full at one time such as insurance or property taxes. If you know a large payment is coming due, you need to plan ahead for it and make sure you have enough cash set to the side to make the payment. Be prepared and organized!
- Set Up Monthly Payment Plans Where Possible: Some insurance companies will let you pay monthly, but be aware that they sometimes charge a financing fee for doing so. If you want to avoid that fee, set up your own automatic savings plan where you transfer some money each month, or each pay period, to your savings account so that you have enough saved up for when those larger expenses come due.
- Keep a Close Eye on Account Balances: Make sure you have enough money to cover your expenses, especially in your main checking account. It’s easy to lose track of cash flow when we get caught up in day-to-day activities. But small expenses do add up and you don’t want to end up paying bank overdraft fees that you could easily have avoided by simply checking in on your balances regularly.
- Create a Cash Flow Cushion: Save a little extra money each month or from each pay check to cover cash outflow surges like bulk buys. My husband recently bought 20 cartons of orange juice on sale. We saved a significant amount of money, but the upfront expense put a strain on our cash flow. However, we covered the discrepancy by using our cash flow cushion and were able to avoid taking on any debt. And for those emergencies that you can never plan for, make sure you build an emergency fund as well.
Everyone’s cash flow situation is different. Some of us receive a regular salary, while others have irregular income and expenses that make it much more difficult to figure out how to budget. The key is to have a firm grasp on your unique cash flow challenges and have a plan in place for avoiding the dreaded cash flow crunch.
How do you handle cash flow?