Why managing your cash flow changes your life
Australia’s net household savings ratio is -2.4%. Just 30 years ago it was 10%. Hardworking Australians in strong economic times are not good at managing their cash flow.
Looking and feeling rich, with a nice car and house packed out with luxury consumer goods, can be loads of fun. And the cause of emotional and financial stress. Although such goods are tangible — and probably quite easily saleable — they are not assets that generate money; they cost money.
Yet lots of people are buying up big: average Australian household debt is equals 1.3 years of income, according to National Centre for Social and Economic Modelling (NATSEM) figures.
The causes of this high-debt, low-savings situation are many. Two major ones are easy credit access (via credit cards or even mortgage redraw) and the fact that our long economic boom means many young people can’t remember the last recession (1990), so don’t understand the need to save for not-so-good times.
Not understanding the four parts of cash flow — income, expenses, assets and liabilities — or how they work, just compounds bad money habits.
But good money habits can be learnt. Firstly, this takes knowledge, to understand how cash flow works, and equally, how approaching it incorrectly will work against you. Secondly, it takes discipline. This is not just the discipline to save, but to stick to a financial strategy. The most effective way to do this is with the help of a financial planner.
Bleak retirement
Low savings and high debt bodes badly for retirement. NATSEM figures also note people retire with higher housing debt than previously, with many using superannuation to pay off mortgages. This, of course, leaves less money for living expenses.
Neither is downsizing an easy option. Sometimes it’s emotionally hard to leave an area or the family home; it may be impractical to move to cheaper housing with fewer amenities and less infrastructure; or, the price achieved may be less than you counted on.
Goals and a vision
A plan needs a purpose. Write down what you want to do with your money — not the money you have now, but some goals that will require you to improve your financial performance (after all, that’s at the core of why Summerhill exists!). Your goals may be travel, or a holiday house, or earlier retirement, whatever is important to you.
Your goals should be SMART — specific, measurable, achievable, realistic and have a time frame. They’ll also need to consider your age and health, short and medium-term obligations, your predicted income and your current debts and assets. Review them regularly, so they are still relevant.
A cash flow plan
Now you have a purpose (or several), you need a plan to get there. A cash flow plan should begin with the end in mind — and then make provisions to enjoy the journey. A frugal life, waiting for “one day”, is a life not enjoyed to the fullest.
A good cash flow plan will include several steps:
- know your expenses (record outgoings for a while if you’re not exactly sure)
- write a budget (food, mortgage/rent, clothing, utilities, rates, insurances, pets, house/garden, entertainment, etc.)
- cover basic costs first
- put aside extra, into a separate account if necessary; it doesn’t matter how much, the discipline of doing it will see this grow (as will seeing a financial planner!)
- get professional advice: financial planners can help with many areas; for instance, “financial coaching” is part of Summerhill’s services
Your balance sheet
It’s not just businesses that benefit from “balance sheets”.
Everyone should know their own assets, liabilities, income and expenses. It can help to think like a business. Work out your “income to expense ratio”, to track what you’re spending (expenses) as a percentage of what you’re earning (income). This will tell you if — and where — you need to cut back.
Also write down what you own (assets) against what you owe (liabilities).
Review both these ratios every year. Are you improving? Treading water? Or are you like the frog who hasn’t realised the tepid water has become boiling?
Which pattern are you?
There are several cash flow patterns people fall into.
1. Hand to mouth: a surprising number of high-income people fall into this category, as well as those on the bread line. In this pattern, money earned goes straight out again as expenses. Rarely does it include building assets, such as investments. This pattern also tends to use short-term credit such as credit cards, and juggle them all around. If circumstances change (ill health, job loss, etc.) those in this pattern suffer with lack of savings and “real wealth”. It also, inevitably, ensures a low-quality retirement lifestyle.
2. Hand to bank: money earned is divided into paying living expenses, with the rest going on high-end consumer goods. So while money may go towards a mortgage (and, don’t forget, the interest portion is an “expense”), the rest is also handed to the bank to cover short-term credit. This pattern looks rich, but behind the façade, no money is being put into savings or building assets that generate money (such as investments). This pattern arises from a lack of understanding about assets and liabilities. An “asset” will make you money (or “feed you”), while a “liability” will cost you money (or “eat you”).
3. Growth: this pattern is very different: money coming in covers expenses, with another portion going towards cash-generating assets. The cash from these can cover other expenses or be ploughed back into investments to make more money, thus creating a wealth-building cycle.
Genuine financial success comes from the third cash flow pattern. Creating positive cash flows, and investing in assets not liabilities, generates additional sources of income.
Cash flow killers
Lack of financial knowledge, lack of a plan and lack of discipline will all get you into debt — and varying degrees of trouble.
Often, the “slide” begins with buying a home. With your “good risk” house as collateral, banks may soon extend increased credit card limits, which can be maxed out on furnishing or upgrading parts of your new home.
While credit cards used that way kill cash flow, a mortgage redraw facility is not necessarily the answer. Although it has lower interest than a credit card, a redraw facility means the amount you can borrow is now linked to the size of your house, not your income. So you have access to a heap more credit, but without any increased ability to pay it. Only the rigorously disciplined will keep their focus on reducing debt, not just paying the bank-allocated minimum.
Using a mortgage redraw facility, rather than a separate account, makes it much harder for you to stay focused on your cash flow, and you can end up paying for the important things — covering expenses and investing — last.
Many people stuck in this cash flow-killing pattern think working harder is the only way out. But if the model is flawed, that is neither a sustainable answer for them personally, nor financially.
Take control
Your cash flow must be visible and transparent. Ideally, you need a single account that money comes into, from which you can apportion to other accounts for different purposes: everyday living expenses, mortgage, super, investments and so on.
Tags: Cash management, savings