Investment Glossary – Cash Flow

About 100 yards from where I live today, there’s a little stream that wanders through the woods. It’s about eight feet wide, maybe a foot or so deep in the middle, and to be honest, it doesn’t really have much of a current. About three miles away, it eventually meanders its way into the Charles River, which in turn flows into Boston Harbor and the Atlantic Ocean. So I take comfort in knowing that the water that slowly flows past my house eventually ends up in the ocean, where I can swim in it during the summer and look at it in the winter wondering how the heck it doesn’t freeze.

All of these bodies of water have different flows at different times. My little stream peaks in the spring with the melting snow, and also in the fall with the rains that tend to come before December. The Charles River also tends to see peak flows in the spring, but declines throughout much of the rest of the year until the next winter starts. And the flow in Boston Harbor and the Atlantic Ocean tends to vary over the course of the day because of changing tides, though the North Atlantic Current running just off the coast tends to keep much of the ocean water flowing in the same direction on a consistent basis.

Cash flows are no different than the flows we see in these bodies of water. Cash flow measures the relative direction that money moves within a household, business, or country. In this case, we’re most concerned with looking at your household. So when we talk about cash flow on a household basis, we look to examine your income compared to your expenses. A household with positive cash flow generates more income than expenses, while a household with negative cash flow generates more expenses than income.

Just like the bodies of water mentioned above, household cash flow may fluctuate over various periods of time. For example, most people are paid every week or every two weeks. So the majority of days feature negative cash flow, as you tend to have expenses but no income showing up in your bank account. On the other hand, when you get to payday, you have a significant amount of positive cash flow, as you receive compensation from the previous week or two weeks of work, but don’t typically have two weeks of expenses built up – until you have to pay your mortgage or rent at the end of the month.

There are also some expenses you may have to pay quarterly, on a semi-annual basis, or annually.

Property taxes, car insurance premiums, and homeowners insurance all fit into one of these categories. These can cause significant disruptions to cash flow when they occur, even though for the rest of the year, they appear to have no impact.

Let’s look at an example to make it clear. Suppose I work as a park ranger and earn $48,000 per year. That means I earn $4,000 per month. That’s my income. My expenses include things such as income taxes that are deducted out of my paycheck along with my health insurance, my rent, my weekly trips to the grocery store, electricity and heating expenses (since they aren’t included in my rent), an internet connection and a subscription to Netflix since I can’t get enough of The Crown, and then a little bit left over for some spontaneous fun events. Let’s say that all of those things cost $3,200 per month. That means that I have $800 each month left over when my expenses are subtracted from my income, meaning my cash flow for the month was $800. If I made $1,000 less per month but still had the same expenses, that would mean my cash flow is negative $200 per month, meaning I’d have to turn to borrowing to afford the same lifestyle. That borrowing could take the form of credit cards, payday loans, or other debt in order to make ends meet.

All of this gets at one of the key ideas of cash flow – that while it’s nearly impossible to be cash-flow positive over the course of every single day, when we look at how to build a budget, the goal is to be cash-flow positive over a month or a year at a time. The fluctuations that occur from unexpected expenses can be offset by building a properly-sized emergency fund, also paid for out of cash flow that is diverted to savings, rather than towards additional spending. Budgeting is really about cash flow management, and understanding that while your income and expenses may occur and different points in the week, month, or year, you still have to strive for that long-term balance.