This piece is part of a series I'm calling Money 101 and is designed for those who might not be as advanced in their personal finance knowledge and experience.
We've discussed the fact that you need to track your net worth, but there's another measure that you should keep an equally close eye on. It's your "cash flow."
Cash Flow Definition
Cash flow is simply income less expenses. It's the amount of surplus you have after you've paid all your bills. The difference is then what you can save and/or invest. If you remember my post on how to become wealthy, you know that it's a vital part of becoming wealthy.
This is why I will talk about the two parts of creating a strong cash flow -- maximizing your income and limiting your expenses -- so often. If you can grow the former and keep the latter in check, your cash flow will skyrocket, fueling your net worth to new and glorious heights.
The Budget through the Years
The budget is the method most used for tracking/setting/managing cash flow. It's an invaluable asset in my opinion, but the level at which you need to develop and use a budget differs based on your financial position:
In the early years of managing your own money (or when you're "starting over" with little to your name), a budget is invaluable. It will help you see where your finances are going and how they are spent. It will enable you to catch things that otherwise might not be noticeable and assist you in making good financial decisions. I highly recommend having a budget for people just starting out handling their money. I would make it as detailed as possible and review/update it on a regular basis (like monthly.) This is what we did for the first decade or so of our marriage, and it made a HUGE difference in how we manged our maonet and the financial results of those efforts.
After you become a bit more proficient in managing your money (and have developed a larger surplus between income and expenses), I think you can go to a less detailed and less frequently updated budget. If you've proven that you can manage your money (and especially control your spending) a budget isn't needed nearly as much to ensure your cash flow remains strong. I'd ease into this process but updating and reviewing a budget quarterly, then semi-annually, then annually. If you get really good at creating a surplus and watching your spending, you can eventually get to the point where you don't need an official budget at all -- you can simply review spending in real-time as needed. This is what we currently do. We look at spending in Quicken and make adjustments as needed, but we don't have a formal budget.
Finally, as you begin to approach retirement (or early semi-retirement), you'll need to go back to the basic budget. You'll want to be 100% sure that your income and expenses are where you want them to be before you make any major moves because once you do, it's hard to go back (for instance, hard to go back to work, hard to cut expenses that are now fixed, and so forth.) For these reasons, I suggest you do a very detailed, multi-year budget well before retirement to see if you can afford to make the changes you want to.
How They All Fit Together
Here's how all the financial pieces we've discussed so far fit together:
- A budget allows you to see where your money comes in (and how much and when) and where it's spent. It's the mechanism for determining and tracking your cash flow.
- Your cash flow reveals the surplus (income less expenses) that you have each year to be saved/invested.
- These savings/investments increase your net worth and, over time, allow you to become wealthy.
By tracking cash flow on a regular basis (with a budget) and using the information generated to make appropriate adjustments, you can take steps to significantly grow your net worth over time and ultimately meet almost any realistic financial objective you set for yourself.