You can’t earn your way to financial freedom

Cash flow

I have written about cash flow management a couple of times previously (here and here) because it is the most important thing to master in order to build wealth. It is also the reason that most people fail to build wealth. In fact, I have never met a wealthy person that doesn’t have good cash flow management. That is not to say they don’t spend money on luxury items. They only spend on luxury items that matter to them.

The purpose of this blog is to show you how to master cash flow management in a very simple, easy to follow way. You don’t have to become super-tight or track every cent you spend. You just need to become a ‘conscious spender’.

Money just goes… if you let it

There’s a saying that “a vacuum always fills” and this applies to cash flow too. I notice that with most people, living expenses rise in line with income increases. And most people spend whatever they earn. There is always something to spend money on. A better home, better clothes, better schools, better holidays, better restaurants – and the list goes on! Our ego wants us to spend all our money on “better stuff”. We tell ourselves we are worth it. We’ve worked hard so we deserve these “better things”. But don’t let the ego win! Ego really is the enemy of successful wealth accumulation.

The difference between people that have successfully built wealth and those that have not is that wealthy people are very deliberate about their expenditure. They don’t waste money. They think about everything they spend money on and if it’s something that is not important to them, they will find the cheapest option or eliminate the expenditure in full. It’s all about value for money. Very few things are purchased on impulse. If it’s something that is important to them, they are happy to pay a premium (luxury price). However, in reality, there are few items that meet this definition. In short, wealthy people are smart with their money. It is not smart to buy something you aren’t going to care about in a few weeks’ or months’ time – irrespective of whether you have the money or not.

Rich people know they can buy everything they want

Sometimes people spend money on items to make themselves feel special, successful or even rich. For example, only a small percentage of the population can spend $700 on a pair of shoes, so “I must be rich” they tell themselves.

However, rich people tend to operate differently. Rich people want to feel smart about their spending. They know they can buy all the brand names they want – there are few limits. So, its not about whether they can afford it. Therefore, it tends to come down to only two questions; (1) do I really need or want this item and (2) is it good value-for-money? Rich people know that’s what sets them apart from the vast majority of people i.e. they know how to be smart with their money. It has nothing to do with proving they are rich (by buying more stuff).

Therefore, change the story in your head. Tell yourself that you are rich. That you can afford to buy whatever you want if you really wanted to. But the desire to feel smart with money is stronger than the desire to feel rich.

Why is a cash flow surplus so important?

If we spend all our income, we will have nothing left over to save for tomorrow (retirement). However, if we save a bit and spend a bit, we can enjoy life today and feel comfortable that we’re building wealth for tomorrow. In essence, you need to spend less than you earn and invest the difference on a regular and consistent basis. If you can’t achieve that, it’s very unlikely that you will have a comfortable retirement. For most people reading this blog, superannuation will not be sufficient to maintain their current standard of living for the rest of their life.

In terms of what you should do with your cash flow surplus, well that depends on your circumstances. There are lots of options including repaying debt (extra repayments or money in offset), additional super contributions, borrowing to invest (i.e. servicing borrowing costs), investing in shares, saving in cash/term deposits and so on. If you are stuck, this video might give you a hint about which of these options might suit you best. Of course, you should seek independent, professional advice. 

You can’t manage what you don’t measure

As the subheading says, you cannot manage what you do not measure, so that is your first step. If you do not know exactly what you spend (I don’t mean guess), you must work it out. Once you have done that it will reveal three very important numbers:

  1. How much on average you spend each fortnight or month – this is important, and the figure might surprise (scare) you. It will also then allow you to calculate how much surplus cash flow you have to invest.
  2. The split of your expenditure between discretionary (shopping, eating out, etc.) and non-discretionary (food, health, insurance, utilities, etc.) items. This will be important in future planning i.e. you know how much cash flow you really need to survive.
  3. If you are spending money on discretionary items that add very little to your standard of living (enjoyment) – these expenses are wasteful and should be minimised or eliminated – especially if you can’t afford it!

These few pages (click here) from my book Investopoly will walk you through the process of quickly ascertaining how much you spend and on what. In summary, you download all your transactions for the past 3 months into a spreadsheet and allocate them into 7 categories and look for trends and savings. Check out our list of financial hacks for saving ideas, especially utilities.

In this video I walk you through the process i.e. how to download your transactions from internet banking and sort then in Excel.

Once you have completed this exercise, it should be easy for you to calculate the three important numbers referred to above. In this blog, I set out what you should be spending – so check this out to ascertain whether you are “spending too much” or living beyond your means.

Two easy steps to rectifying your spending behaviours

What do you do if you identify you don’t have any surplus cash flow and/or you feel you are spending too much money? Well, there are two steps that you can take that I have found to be very effective, both personally and professionally.

One-month spending embargo

For many people, spending habits are very similar to eating habits. That is, unless you consciously exercise regular discipline (i.e. say no to the little voice inside your head that is telling you to say yes… e.g. eat that additional bit of chocolate), your behaviour will slip, little by little, and bad habits form. Before you know it, you’re eating whatever your little voice tells you. Spending is no different – it takes conscious and regular discipline.

The best way to recalibrate your spending is to agree to a self-imposed spending embargo for a period of time, such as one month. During this month you avoid any discretionary spending and save as much money as possible. One month is short enough for you to stick to it (because it is unsustainable to not spend any money on discretionary items) but long enough to make you take notice of your spending habits. There are two benefits of doing this. Firstly, it highlights how much you really spend – all the small items do add up! Secondly, once the embargo is over, you will find that you are more conscious about your spending decisions. The one-month embargo should help you break any poor spending habits you may have slipped into.

Set up your banking so that your surplus is locked away

Similar to the method popularised in the book, The Barefoot Investor, you should operate multiple bank accounts. That is, it is probably okay to continue to operate your accounts exactly how you have been doing so except for establishing a new ‘surplus bank account’ (this could be an offset account linked to a loan). If you have worked out what your surplus income is (or should be) $20,000 per year, then set up an automatic transfer of $770 per fortnight into that ‘surplus bank account’ and don’t touch it. You can then spend what is left over. As Mr Buffett says, “Don’t save what is left after spending; spend what is left after saving.”

How often should I check my cash flow?

Ideally, you should undertake this cash flow analysis (i.e. review past 3 months of transactions) every 12 to 24 months as bad habits can form slowly and go unnoticed. That said, if you are operating a ‘surplus bank account’ as described above, it will be very easy for you to monitor your compliance.

And once you have your cash flow under control…

If you feel confident that you have control over your cash flow and you have a surplus to invest, it might be time to map out at long term investment strategy to ensure you are investing that surplus as efficiently as possible. In that regard, I would welcome the opportunity to have a chat, click here.