Cash Flow
One of New York’s greatest philosophers once said, “cash rules everything around me (C.R.E.A.M.).” At the core of this bar is the essence of personal finance management.
In this post, I’ll share how I think about cash flow and what I consider to be the most pragmatic ideas to understand concerning cash flow. These ideas include transactions, cash, income streams, active vs. passive income, budgeting, and living below your means. When you understand the basics of these ideas, you’ll know enough to begin learning about the second of my seven personal finance management topics: insurance.
Cash and Transactions
Personal finance management is fundamentally about the management of transactions involving money. A transaction can be thought of as an interaction that involves the movement of money from one place to another. Whether we’re trying to have more money flow into our pockets, stop money from flowing out of our pockets, or move money out of our pockets towards something we value (by buying something or investing), we’re attempting to control the flow of money into and out of our pockets.
To put it differently, personal finance management is fundamentally all about cash flow. For our purposes, I’m taking cash flow to describe income (cash coming in) and expenses (cash going out). Broadly speaking, this concept can apply to us both as individuals and as groups like families, households, and companies1.
As you learn more about cash flow, you’ll likely encounter people making a distinction between cash and money. What is cash and how is it different from money? And how much do you need to care about these terms? (Spoiler alert: you don’t have to care much about them unless you’re unbanked.)
The meaning of these two terms can vary depending on the context at hand1, but they generally have very similar meanings and are often used interchangeably. Without getting too caught up in the terminology, here’s what we can all agree on: money is a storage of value. You can exchange money for something else of equal value. In other words, you can use money to buy things.
Money can come in different forms including cash, checks, and money orders.2 Money in the form of a tangible currency (like a dollar bill or a coin) is considered cash. Cash is special because, compared to other forms of money, it can be used in a transaction immediately without much complication or extra work. For our purposes, I’ll consider money stored in bank accounts to be cash as well.
In general, people who have money that’s not in a cash form seek to convert that money into cash (e.g., cashing checks). Once cashed, the money becomes easier to use in other transactions (e.g., to make purchases).
The process of converting non-cash forms of money into cash is in and of itself a transaction. This type of transaction is an example of a financial service, which can cost you time and money. As a rule of thumb, if you want to limit how much you pay for financial services like these, you want to do a few things.
First and foremost, you want to avoid converting to and from cash unnecessarily. If given the choice, it’s often cheapest for you to make money transfers using cash. Outside of unique scenarios where the backing of a financial institution is needed, you can avoid purchasing money orders, cashier’s checks, and even check books.3 Similarly, if given the option between being paid by an employer via direct deposit or check, people with bank accounts can avoid unnecessary conversions of checks to cash by opting to receive payments by direct deposit.
Second, you want to set yourself up with a bank or credit union that helps you avoid some of these costs. Nowadays, many banks and credit unions enable customers who deposit cash into the bank to cash checks for free. There are US bank accounts available for most people (including US residents, foreigners, and non-residents).
Third, when you’re unable to avoid these cash conversions, you want to choose the cheapest option. Different companies will charge different amounts for the exact same service. Cashing a $500 payroll check at Walmart will cost you up to $4. Cashing the same check at a Currency Exchange can cost you as much as $13 (2.4% of the $500, or $12, on top of a $1 flat fee). That’s a difference of $468 if you cash a $500 check once a week 52 weeks out of the year.
Practically speaking, the distinction between money and cash can be important for individuals who are unbanked. Individuals who use banks can do just fine managing their own personal finances without worrying too much about the distinction between cash and money. For these individuals, it’s often more productive to think about income and expenses.
Income
Income is cash that comes into your pockets. The wages you earn from a job are examples of income. You can have more than one source of income. The more income sources you have, the less dependent you are on any one of those sources.
Income lives on a spectrum of active to passive. Active income is income earned by trading in time for pay on an ongoing basis. A traditional job that pays an hourly rate is considered an active income stream because it pays employees according to the number of hours worked. Freelance (a.k.a. gig, on-demand, or project-based) work also falls under this category.
Passive income is income earned without the need to trade in time for pay on an ongoing basis. A dividend is an example of passive income. A dividend is a payout of a company’s earnings paid out to the owners of the company.
Building a passive income stream can involve doing work upfront to create a product that is then sold with little to no additional effort. For example, YouTube content creators when people view their videos. These content creators have to do work upfront to film, edit, and upload videos to YouTube. After that, they don’t need to do as much work, as people can continue to find and view the videos long after they’ve been posted online.4
Similarly, musicians may passively earn royalties every time listeners stream their music, but must do a lot of upfront work to write, practice, record, produce, and distribute their music. Sponsored athletes (like NBA players) may also make royalties from endorsement deals (like sneaker deals), but typically train for years before reaching the highest levels of their sports.
As these examples illustrate, the upfront work involved in building passive income streams may require investing lots of time and energy with little to no financial reward along the way. Why would anyone invest so much time and energy building passive income streams when they can build active income streams instead?
Unlike active income streams, passive income streams have the potential to make you financially free, or free to live the life you want without depending on a job to cover your living expenses. The process to build these income streams can be slow and require some sacrifice initially, but the payout is invaluable. People who reach financial freedom early in life may choose to retire early, dedicate all of their time towards what matters most to them, and live without stressing about finances. Active income streams do not provide those luxuries because this income stops coming in as soon as the worker is off the clock.
What does it take to achieve financial freedom? Reaching this milestone requires having enough money saved, invested, or coming in through passive income streams to cover all living expenses for life. How much money is that exactly? To know how much money you’d need, you must first know your living expenses.
Expenses
An expense is cash that leaves your pockets. Your rent / mortgage, utility bills, and grocery bills are examples of expenses. Understanding your expenses is key to managing your cash flow.
Budgeting is the planning and management of income and expenses. Budgeting is a skill or practice that involves the categorization and tracking of expenses. That means recording each transaction in a given time period, going through every individual purchase, ensuring you recognize each purchase, assigning the amount spent on each purchase to a category, and adding up the total amount spent within each category.
I would argue budgeting is the single most important exercise that anyone can perform to help manage their personal finances. If you don’t stick to a budget, you may struggle to ensure your money goes toward the things that matter most to you.
Your ability to save and invest entirely depends on your ability to live below your means, or to spend less money than you make. If you consistently spend all of the money that you earn, then you simply won’t have any money left over to save or invest.5 If you aspire to consistently save and invest, you’re going to need to live below your means. A budget can help you track your expenses so that you can determine whether you’re living below your means and course-correct as needed.
A good budget should help you answer the following questions: how much money do you make on a money basis? How much money do you expect to spend on a monthly basis? How much money do you actually spend on a monthly basis?
The difference between the answers of these last two questions should indicate to you that you may want to adjust your spending habits. It’s important that we don’t skip this step. It’s easy to assume that what we actually spend will usually be close to what we expect to spend. That very assumption is what makes this exercise so eye-opening.
Have you ever underestimated how long it would take you to get a certain task done? We often do the exact same thing with our spending – we underestimate how much we actually spend in a given month. Going through this exercise typically helps people become aware of all sorts of things like subscriptions we don’t use that we forgot we’re paying for to just how much it’s costing us to eat out for lunch everyday.
Knowing how much you actually spend in a given month is also very important for retirement planning. If you want to maintain your current standard of living after you’ve stopped working, it’s important to know how much money you’ll need saved up to cover however many years we have left. (This is another sobering exercise. Did you know that If you spend $3,000 a month and hope to be around for another 20 years, you’ll need to have upwards of $720,000 saved up?)
A good budget might also help you answer the following questions: what are your biggest spending categories? How much money do you have left over at the end of every month to put towards savings or investments? Knowing this number becomes especially important if you need to plan for large purchases (like a car, a wedding, or a house) or for retirement.
At minimum, a good budget should enable you to accurately categorize expenses in a way that makes sense. For example, a budget might categorize spend in terms of needs and wants. Non-discretionary spend is money spent on essentials that you need to get by, such as groceries, the roof over your head, power, hygiene supplies, and healthcare. Discretionary spend is money spent on everything else, such as dining out, entertainment, and shopping.
Having some level of categorization will enable you to evaluate whether you’re spending a reasonable amount on different areas. For example, if you find that 50% of your paycheck is going towards rent but everyone says you should aim to spend no more than 30% of your check on rent, then you might want to consider finding a roommate or finding someplace else more affordable.
There are many ways to budget. Some people choose to track expenses weekly while others track expenses monthly.
There are also many different tools available to help us budget. Some people prefer to pay for high-end budgeting apps that provide helpful features like notifications and automated data imports. Others prefer to work off of free templates downloaded from the internet. Still others prefer to create their own budgets from scratch in a spreadsheet or in a notebook. There’s no one-size-fits-all solution. You should feel empowered to choose the solution that works best for you.
Budgeting can feel like an errand because there can be a lot of manual effort involved tracking expenses. The trick is to make budgeting a habit so that you can knock it out quickly and consistently. If you’re just starting out, I suggest tracking expenses at least once every other week. Any less frequent than that and not only will it be hard to develop the habit, but it may also be frustratingly difficult to remember what you bought over two weeks ago.
I also suggest starting with a reputable template or app available online. That way you minimize the risk of missing an expense category or feeling overwhelmed by the task of creating a budget from scratch. When you have time, it can be helpful to explore different tools to see what might appeal to you most. That said, I don’t want you to feel pressured to find the perfect tool before getting started. If you don’t love the tool you start with, you can always switch to a new tool in the future. After all, you’re the boss of your own personal finance journey. I’ve already used a handful of different budgeting tools myself, and I’m sure I’ll end up using more in the years to come. It’s less important that you start off with the perfect tool or that you know how to use it perfectly the first time. It’s much more important that you start if you haven’t already.
Conclusion
There’s a saying that if you fail to plan, you plan to fail. This wisdom holds true for managing cash flow by budgeting. Budgeting is the foundation of everything in personal finance management, especially cash flow. By understanding your expenses, you equip yourself with the information needed to set the right income goals for you and put your money where it matters most. If you take one thing away from this post, it’s that you should be budgeting.
Some people believe they don’t need to budget because they feel confident that they currently spend less than they make. Even for those people, budgeting can still be a worthwhile exercise. Having a budget sets you up to strategize how you fund your savings and investments, determine whether you’re overspending in any areas, and feel secure knowing that you’re maximizing the value you get from your spending without worry. Frankly, in today’s cost of living, it’s too risky to not have a budget.
With that, we’ve covered the information I believe you need to confidently make cash flow decisions. Stay tuned for the next post, where I’ll dive into the topic of insurance.
Footnotes
1 Many finance terms have very specific definitions in the context of businesses and accounting. In the context of personal finance management, being financially literate does not require you to know how businesses and corporate accountants define these finance terms. It’s much more important to understand the broader concepts and skills. To avoid confusion, I will generally avoid getting into the nitty gritty details of corporate accounting jargon.
2 Assets like real estate, stocks, and precious metals can also store value. Assets generally need to be sold before the value therein can be used to make purchases.
3 Sometimes, you won’t have the option to avoid converting cash into another form of money. For example, if you want to purchase a real estate property, you may be required to put down “earnest money,” or an early deposit demonstrating your intent to purchase the property. Earnest money will often only be accepted in the form of a cashier’s check or a money order because they are more secure and reliable than cash and personal checks. Cashiers’ checks and money orders are considered more secure because they are backed by other financial institutions.
4 In practice, many content creators do some additional work to market their videos (e.g., sharing videos on other social media platforms).
5 Although it may seem obvious, it’s worth explicitly stating that if you consistently spend more money than you make, (given enough time) you will eventually run out of savings and end up in debt. Some people sometimes have the misconception that a raise, a promotion, or a new higher-paying job will be enough to help them solve debt issues. But more income will only allow you to reduce your debt and pay yourself if you manage to keep your expenses under your income. Even millionaires can end up living paycheck to paycheck if they don’t manage their expenses. There’s no way around it – to improve your financial standing, you must live below your means.