By FPA member Evan P. Welch, CFP®
Last Updated: May 24, 2010
There are several ways to gauge your financial health. Knowing your personal balance sheet, often called your net worth statement, measures your total assets minus total debts, and thus provides an indicator of your financial position. A second indicator, and the focus of this article, is your cash flow statement, which measures your net monthly and annual cash flow.
One of the fundamental building blocks for wealth creation and long-term financial security is spending less than you earn. Many people, whether of high or low income levels, fall into the trap of over-spending and building debt, creating stress as they try to feed their spending habits.
People usually travel on one of three "tracks" in terms of their cash flow:
- Strong (saving 20 percent-plus of income)
- Stable (saving 10-19 percent of income)
- Weak (saving under 10 percent of income)
Those who have fixed or committed expenses under 65 percent of their income, and discretionary spending below 10 percent of income, tend to be in the strongest financial condition.
Build your cash flow statement in the following way:
- List your income streams, such as salary, bonus, rental income, Social Security and pensions.
- List your regular committed expenses, such as real estate taxes, utilities and groceries; and your discretionary expenses, such as vacations and dining out.
- Add your monthly and annual savings such as 401(k) contributions and deposits to your cash reserves.
Review these two examples of cash flow statements. Table A shows a person with a strong cash flow statement, and Table B illustrates an individual with a weak cash flow statement. Notice in Table A that the client saves $53,500 per year (33 percent). She has committed expenses of $84,300 (53 percent) and discretionary spending of just $12,500 (eight percent).
Though client B has the same income as client A, he drives expensive cars, frequents posh restaurants, and saves less than 8 percent of income. If client B chooses to get on a stable track, he will need to adjust his habits and lifestyle, and while difficult, this change may lead him to a life with more choices.
Building a cash flow statement, and making regular updates to this statement, can be an effective strategy for strengthening your financial position and moving toward your financial goals.
FPA member Evan P. Welch, CFP®, works with individuals, families and physicians, to help them achieve their financial objectives through a long-term relationship based on knowledgeable advice. His firm is located in Boxborough, Mass.