When it comes to personal finances, it helps to think in terms of “Cash Flow”. Simply put, cash flow as it pertains to businesses refers to the total amount of money being transferred into and out of a business. Cash flow as it pertains to us is the total amount of money being transferred into and out of our personal accounts. Having an understanding of what your cash flow looks like is crucial to successfully managing your money and understanding:
- Where you’re making money
- Where you’re losing money
- What to do about it
You need a framework to understand your own cash flow. Think about your personal finances first in terms of Money In and Money Out.
- Where You’re Making Money
As the names would imply, Money In refers to any money that comes into our accounts on a regular basis. Paychecks, Housing Allowance, Subsistence Allowance, and Uniform Allowance are all examples of Money In. It looks like this:
Money In, otherwise known as Income, comes typically in one of three varieties. The first type of income, which we’re all intimately familiar with, is Active Income. Active Income is what you receive for doing your job. This looks like anything that comes from the Department of Defense or another employer in return for your time and effort, such as the examples in the graphic above.
The second type of income is known as Passive Income. Passive income, simply stated, is money that comes in that requires little to no daily effort on your part. An investment property is the most common example of passive income. With an investment property, after doing the initial legwork required and occasional maintenance, you receive money on a regular basis with little to no effort. There are countless ideas out there on how to generate Passive Income, and we’ll push forward more material with effective ways to do it. For the purposes of understanding your own cash flow, just understand that Passive Income is a fantastic thing to learn how to create.
The third type of income is typically referred to as Portfolio Income. This is the money that you generate through buying and selling stocks, bonds, mutual funds, etc. This is a story of its own that can be both highly rewarding and highly dangerous at the same time. Before trying to generate your own portfolio income, you want to do a lot of homework prior to putting money into any single stock or even a specific mutual fund. However, for the purposes of understanding your own cash flow, it is important to understand that there is a huge potential to supplement your Active Income with Portfolio Income. Here’s the updated snapshot of our Money In.
- Where You’re Losing Money
Money Out refers to any money that regularly goes out of our accounts. Everything from an energy drink at a vending machine to a mortgage payment is Money Out. It can look and feel chaotic if we’re not on top of it:
Just like we broke Money In into three categories to better understand where our money comes from, let’s do the same with Money Out: Necessary Expenses, Discretionary Expenses, and Assets.
Necessary Expenses are the expenses which we all have no real choice but to pay. Think taxes, mortgage or rent, car payments, car insurance, food, gas, phone bill, internet, etc. These are the types of things which are typically listed on a budget and which end up taking up a sizable chunk of our income.
Everything we spend our money on that we don’t need is a Discretionary Expense. Think going out for dinner, alcohol, energy drinks, video games, suspension kit for a truck, etc. If it’s fun, chances are it’s a discretionary expense. Discretionary Expenses are not necessarily bad, but they can add up quickly if we don’t pay attention.
Finally, and most rarely, our Money Out can go towards Assets. Assets are anything that we put our money into that makes us money in return. Examples include stocks, mutual funds, rental properties, side businesses, etc.
Put concisely, we spend our Money In on things that we need (Necessary Expenses), things that we like but don’t need (Discretionary Expenses), and, if we’re smart, things that can make us more money (Assets). Here’s the updated snapshot:
3. What to do About It:
Money In comes from Active Income, Passive Income, and Portfolio Income. All of our Money Out goes towards a Necessary Expense, Discretionary Expense, or an Asset. Simple. Now what? Now we use this model to:
A. Minimize Expenses
B. Maximize Assets
A. Minimizing Expenses
There are thousands of tips and tricks out there on how to save money on a day to day basis. We won’t add to that list in this article. That said, there are a couple key ideas to understand when it comes to your expenses. The first is that just because something is a Necessary Expense doesn’t mean that you have to pay a lot of money for it. For example, having a car is a necessary thing, and that might mean having to make a car payment every month. However, having a payment of $700 a month for a truck with a lift kit is not necessary, nor is the monthly insurance cost for that truck, nor is the gas that such a truck consumes. The same goes for the type of apartment or home you live in, the type of food you buy, clothes you wear, etc. Just because it is a Necessary Expense does not mean you have to spend a ton of money on it.
Secondly, Discretionary Expenses add up quickly and they are easy to lose track of. A few years ago, I ate either Chipotle or Chick-Fil-A nearly every day for dinner for a few months, costing about $15 each trip. Over the course of a month, that’s about $450. Over the course of a year, that’s a little over $5000. Again, there is nothing wrong with Discretionary Expenses, but be aware that they add up quickly, especially if it’s the type of thing you purchase on a daily basis.
B. Maximizing Assets
All of the money we put towards expenses goes to other people. We pay our phone carrier so that we can use a cell phone, the bank so we can drive our cars, the bartender for fixing our drink, the barista for our coffee, and so on. This is all fine, but understand that this money never comes back. Once you hand it over, it’s gone forever. However, if you put your money in Assets, you not only keep your money but use the money you have to make you more of it. It looks like this:
Wealthy people excel at this last part. They use their Assets to make money whether or not they go to work or stay in bed. If you can have your Assets create enough money to cover your Necessary Expenses, you have achieved what is known as financial freedom. You no longer need to work to provide income because your assets provide it for you. You will only achieve this if you deliberately and consistently save your money to buy Assets that will build wealth instead of spending it in ways where you will never see it again.
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