When you think about building long term and sustainable wealth, what do you think of? What is the key to becoming wealthy?
Most people will answer with some sort of investment philosophy or strategy:
“Max out my 401k”
“Invest in real estate”
“Start a business”
While any of the above can certainly be used to accelerate the wealth building process, they are definitely NOT the number one wealth building tool.
Cash Flow: The net amount of money (or cash) transferring in and out your household
Without a healthy household cash flow, your finances can’t breathe. They need “oxygen” (aka cash flow).
Think about your answers above to the wealth accumulation question. How can you do any of those things without excess cash flow? Let me save you the time, you can’t!
Step 1: Identify the "Spread"
So what is your cash flow made up of?
Income: This one should be pretty straight forward. Where do you make your money?
- Salary/bonus from your job as an employee
- Income from a business you have ownership in
- Real estate income (i.e. from a rental property)
Think of money that actually hits your bank account. Do not include things like growth in an investment account or appreciation of a property you own.
Fixed Expenses: What expenses do you have to pay every single month?
- Income taxes
- Property taxes
- Cable/internet/cell phone
- Insurance premiums (medical, dental, vision, life, disability, auto, homeowners, etc.)
- Child care
- Organization dues
Liabilities: What debts do you have outstanding? While fixed expenses could theoretically go on forever, liabilities have a specific term and interest rate associated with them.
- Student loan
- Home equity loan or line of credit
- Personal loan
- Credit card loan
Variable Expenses: What expenses do you typically incur but vary in amount and frequency from month to month?
- Dining/eating out
- Auto gas
- Personal care
- Car repairs
- Home repairs
The first step in cash flow optimization is getting a grasp on where you stand today. When you lay out all of the above categories, ask yourself a few questions.
- What is the total dollar amount in each category?
- What percentage of gross income do your expense categories and liabilities consist of? I dive into the 50/20/30 savings principle in a previous blog post “Savings Strategies for Six Figure Earners”.
- Is there a “spread” between how much you make and how much you spend? If so, how big is that spread?
- If something doesn’t seem right, make sure you account for money you may already be saving (i.e. into a retirement account). If it still seems off, it is likely a discrepancy in your variable expenses.
Step 2: Widen the Spread
Once you’ve taken a look at your current situation, you are going to want to take steps to widening the spread between your income and expenses. Here are a few ways to do that.
- Increase your income: For most people, this means earning AND asking for a raise. Be sure that you are being compensated fairly. We recently had a client get an offer for a 10% raise, counter it by asking for 25%, and settle on a 23% raise!
- Eliminate or refinance bad debt: We will refer to bad debt as any debt with an interest rate > 8% or so. Pay off low balance bad debt and look into refinancing high balance bad debt. Two categories that often contain “bad debt”, are credit cards and student loans. I talk about the trade off of savings vs investing and some other cash flow strategies in this NerdWallet article.
- Track variable expenses: This is not the most sustainable activity in the long term, but can be a game changer in the short term. For 2 or 3 months, keep track of ALL variable expenses. Set a time every week or every other week to evaluate your spending. Is it what you thought? Are you able to easily reduce certain areas?
Step 3: Level Up
Now that you have created and maintained a “cash flow spread”, it’s time to level up.
- Increase savings over time: If you have been saving 20% of your income every month, set a goal to increase that rate over time. Can you get it to 25%? 30%? 40%? It is always going to be a balance between saving for your future and enjoying your money now. What trade off are you comfortable with?
- Combat lifestyle inflation: This is going to help with the first recommendation. As you make more and more money over time, do your best to keep expenses low (and increase the “spread”). Do you need a bigger house? Nicer car? Expensive clothing? Maybe you do. Just make sure you are aligning your spending with things you actually enjoy.
Cash flow is the oxygen to your financial life. Without it, everything else falls apart. Take the first steps to cash flow optimization.
- Identify the cash flow “spread”: Where is your money coming from and going to?
- Widen the spread: Look for opportunities to bring in more income and reduce expenses and liabilities.
- Level up: Do not get complacent with your wealth building. Keep increasing your savings and do you best to combat lifestyle inflation.