When I was a young analyst at Invesco I worked with a lot of other young singles. Like most generations of young professionals, we often socialized with one another. One of those friends introduced me to my wife. She also offered to set up another colleague with a date, and asked him what he was looking for in a potential mate. I’ll never forget what he said, “The most attractive quality in any potential partner would be positive net cash flow.”
Not exactly romantic, even if it was extremely practical. His argument was sound. He was not looking for someone to financially support him, and he did not care how much money she made. This was not about marrying for money. He was looking for someone who had the discipline to live within her means; and reasoned that if she could do that, then they would be able to live comfortably within their means. Positive net cash flow.
Cash flow is the most important thing we look for when investing in a company, but it is also the most important element of financial planning. Many people refer to it as budgeting, but I do not like that term. Budgeting will get a person in financial trouble quickly. Here is the problem with budgeting.
An individual sits down at the beginning of the new year – this was a resolution after all – and puts together a budget. He budgets among everything else, $5,000 for home maintenance, and $5,000 for a vacation. In May, his HVAC goes caput and he has to replace the entire system. It costs $10,000. He is $5,000 over budget on home maintenance.
In June it is time for his vacation. He knows he just spent $5,000 more than he meant to on home maintenance, but his vacation budget has not even been touched. He goes on his vacation. He also continues to spend on all his other budgeted items. After all, only the home maintenance budget was affected by the unbudgeted item so why would that impact anything else? That is how budgets work in the business world.
Budgeting leads to siloing of expenses – this item comes from this bucket and that item comes out of that bucket. That leads to overspending, which is an obvious problem; however, it is not the only problem.
Here is an interesting fact: most small businesses that go out of business actually show a profit on their last set of financials. How could that be? They spend relative to a budget versus spending relative to cash flow. In other words, the timing of expenses and revenue matter. Using our example again, let’s say our friend budgets $5,000 for vacation, but he doesn’t actually have the money in the bank yet. He based the $5,000 on his expected annual income. He then takes that vacation in February before he has actually made the money. No problem, he thinks; he has credit cards.
Now he has debt and then the HVAC goes. The hole gets bigger, but he is only overbudget on home maintenance, right?
This is how people get in debt. Budgeting is a bad word. What is needed is cash flow management. One way to do this, and the way most credit counseling services will recommend for anyone who is over their head in debt, is to use only cash. In our world today that would mean debit cards. The first thing to do in order to get out of credit card debt is to tear up the credit cards. That is good advice for a lot of people.
However, for those who do not carry credit card debt, focusing on cash flow is still just as crucial in the planning process. The proper use of credit cards can be very helpful. It can make it far easier to see where one’s money is going and to allow one to hold onto her cash a little longer. That is not as much of a benefit today with our extraordinarily low interest rates, but it is still a useful habit. To do that, the rule still needs to be that she does not buy anything with a credit card unless the cash is already in the bank to pay for it.
The appropriate way to plan for that vacation is to set the money aside before the event. That can be done by a process we refer to as cash flow management. While in our working years we should strive to live within our means. It is helpful to know what our major expenses are and to plan for what we need, so that we know what we can afford to save. My first boss referred to this as “paying yourself first.” Put that money in savings before you spend a dime.
My wife and I have tried to start this process early with our children. They each get an allowance, and with every allowance, they must set aside 10 percent to give and 10 percent to save. The giving comes from our family’s faith, but I would think it is a good exercise for anyone. The saving is for the unforeseen or bigger purchases. This is what my colleague was looking for: positive net cash flow. If every young person would start their career with this practice, they would end up in a good place.
Cash flow is not just for those of us still working. In retirement, cash flow is just as important. One of our primary roles as an advisor is to help our clients understand where their cash is going and how much they really need. This may seem odd, but the more successful the client in their working years, the more likely they need help with cash flow management in retirement. While it is certainly possible to outspend any level of income, higher incomes do make cash flow management easier. As a result, many hyper-focused businesspeople really do not know where their cash is going and how much they really need from their investments.
We spend most of our time at Iron Capital talking about the act of investing. We do this because if one does not invest properly, then it does not matter how well he plans. However, planning is an important part of the investment process. We invest for a reason, and those reasons are significantly deeper than just making money. The cornerstone of planning is learning to manage one’s cash flow. It will help your financial future, and if you are single and looking, it may even help you get a date.
Chuck Osborne, CFA