What is the best way to manage cash flow? Do you need a monthly budget to track every single cent? Or is high-level budgeting ok? And, how much is too much to spend i.e. how do you know if you are over-spending compared to your peers? This blog will answer these questions and many more.
You cannot earn your way to improved cash flow
Have you heard the saying; “it’s not what you earn, it’s what you spend that counts”? Well, it’s true! If you have poor cash flow management habits, it doesn’t matter how much you earn, you will always find it very difficult to save money. I have met people with seven figure incomes and very little wealth to show for it. And I have clients on five figure incomes that have accumulated substantial wealth.
Of course, the more you earn, the more you can “afford” to spend on living expenses. But best-practice cash flow management is mostly about avoiding over-spending – rather than turning into a scrooge. I define over-spending as expenditure that adds very little to your standard of living (or only provides very temporary improvements). Typically, people with poor (or no) cash flow management techniques can trim expenses without it having a material impact on their standard of living.
The cost of doing nothing is too big to ignore!
Sometimes people avoid facing the truth because it’s painful. When it comes to cash flow, they avoid taking steps to manage it better because they fear (or know) they’ll have to make painful compromises.
However, you can’t make a problem disappear just by ignoring it. In fact, ignoring a cash flow problem will only make it worse. You will have to pay the price of poor cash flow management at some point. And the longer you avoid it, the more painful it will be. Worst case is that you will have to sell your home to reduce debt, be reliant on public housing and will have to live off the aged pension – which is less than $36,000 per year for a couple!
You can’t build wealth if you spend everything you earn. The good news is that 90% of people can improve cash flow management pretty easily without it impacting on their standard of living. For others, it will require a painful but necessary adjustment – but less painful than it will be if you continue to spend all your income.
Spending: minimise non-discretionary, more experiences and less “stuff”
There are two types of expenses; discretionary and non-discretionary. Non-discretionary expenses include items such as food, power, insurance and so on. There are ways to minimise these expenses as listed in our financial hacks. Non-discretionary expenses are necessary but really don’t enhance our ‘enjoyment’ of life. Non-discretionary expenses tend to be relatively finite and there’s a limited amount you can do to minimise them. Discretionary expenses are all the things we buy purely for pleasure but could live without (if we needed to).
The main purpose of non-discretionary expenses is to make you happy and give you a sense of enjoyment. Research shows that expenditure on experiences (holidays, sky diving, etc.) have the greatest impact on our happiness compared to buying “stuff”. Buying “stuff” (e.g. designer shoes) typically gives you a temporary hit of dopamine but it never lasts (and you need a bigger hit next time). Let’s face it. We reminisce more about past holidays than we do about past purchases. Don’t use money to change your mood – it’s an expensive treatment plan and never works long-term – spend money wisely to enrich your life.
FIRE stands for Financial Independence, Retire Early and it’s a relative new movement that involves cutting your expenses to a bare minimum so that you can invest as much income as possible. The goal is to build an asset to free you from the requirement to work. Some adopters of FIRE are aiming to retire in their 30s or 40s. The centrepiece of FIRE is expense management. It highlights how impactful expense management can be.[Sidebar: the problem with retiring very early is that it can be an empty victory. Typically, you must replace work with something meaningful otherwise you risk losing a sense of purpose and ultimately happiness.]
How much is too much?
The most interesting observation I have made over the past 17 years is that most people spend a similar amount of money on general living expenses (“GLE”). GLE includes everything except for home loan repayments, investment expenses, additional super contributions, school fees, child care fees, substantial holidays and once-off expenses. The amount of GLE depends on your income, age and children (age and number). The table below sets out the amount of general living expenses for various family scenarios.
Annual pre-tax family income
Average annual GLE
Less than $100k
|Young couple, no kids|
|Couple with 2 kids|
|Couple with 2 kids|
|Family with kids|
More than $750k
I estimate that less than 5% of my clients spend more than $150k on GLE.
Lower your ego and spend within your means
Sometimes we allow our ego to influence our spending patterns. I know people that spend like they are millionaires – but they aren’t millionaires! Now, it’s their money and I don’t judge them for how they spend it. But they must realise that there’s a price for everything. The price of building wealth is making short-term sacrifices. The price for living for today (spending all your income) is likely to be the incapacity to fund tomorrow (i.e. an uncomfortable retirement). But it’s not an all-or-nothing decision. There’s a balance.
Be realistic about your financial means and spend accordingly. If you aren’t in the position to afford business class flights, fly economy or go on fewer holidays. If your financial position doesn’t allow you to spend $1,000 on a pair of shoes on a whim, then don’t. Save up for them over a number of months or years.
It has nothing to do with whether you are worth it or not – that’s ego – and a convenient excuse. It’s all about what is reasonable and sensible. If we listen to our egos, we will end up wasting an awful lot of money. The longer you do that, the harder it will be to recover from.
You can’t manage what you don’t measure
All you need to do is measure how much you spend on GLE and if it’s within the ranges in the table above, then it’s likely you don’t need to do anything – except to continue to track it at a high level. Click here for a description on how to measure GLE.
We are in the process of introducing an automated online tool to help all our advisory clients track and manage their cash flow. This will ensure all our clients will have good cash flow management practices. It will also help us make future financial plans and investments with complete confidence. An additional important benefit is that it gives us confidence that our clients will be able to maintain (or improve) their current standard of living as they move into retirement (because we accurately know what their desired lifestyle costs them).
Steps to take if you are spending more than the above ranges
If you are spending more than the GLE ranges noted above, here are a few possible solutions:
- Identify where the over-spending is occurring. Look for expenses that don’t add anything to your standard of living and cut them. Here are some savings tips from the governments Money Smart website. If you are spending too much on discretionary items, it is possible that you are going to have to start denying yourself – the least painful way is to reduce your spend per occurrence rather than the regularity of occurrence. That is, if you go out to dinner twice per week, continue to do so but eat at cheaper place or limit spend on wine, etc. You will also need to become better at tracking and managing cash flow. You may have track expenditure closely on a monthly basis until you are back on track.
- Get help. Coaching and accountability are a great help when trying to change behaviours and habits. The most obvious evidence of this is personal training. People tend to achieve better health outcomes with the guidance and accountability a personal trainer provides. Therefore, if you need to rein in spending, seek assistance from your accountant or independent financial advisor.
- If you have pre-school aged kids, realise that things will probably get better. The most difficult time to manage cash flow is when you have young kids. Expenses are higher than usual. Income is lower than usual. Sometimes there’s little room for improvement in this situation. Cash flow will normally improve when the kids start going to school – unless the cost of primary private school fees will be greater than any additional earning capacity. In that case, you should start planing for that cash flow now.
Essentially, you need to reduce expenditure until you are living within your means. There are budgeting mechanisms that help you to do this – such as having multiple bank accounts as outlined in Barefoot Investor.
What should you do with your surplus income?
The whole point of improving cash flow management is so that you can allocate a regular amount toward building wealth. Doing so will help you feel more comfortable, safe and ensures you’re well on the way to enjoying a stress-free retirement.
There are a number of things you can do with surplus income including:
- Reduce debt – make additional repayments into your home loan or offset account to reduce your debt exposure – particularly whilst interest rates are low.
- Additional super – most workers can contribute up to $25,000 into super. Employer contributions (the compulsory 9.5% p.a.) are included in this cap. So, if your employer is contributing less than $25,000 p.a., then it might make sense to make addition regular (salary sacrifice) or ad hoc lump sum (personal) contributions into super.
- Borrow money to invest in property. This can be a good ‘forced savings’ strategy – particularly for people that are tempted to spend money on discretionary/luxury items.
- Invest in a low-cost, diversified index fund portfolio (share market). Depending on your situation, you might consider using a conservative level of gearing i.e. contributing $2,000 per month from cash flow and draw an additional $1,000 from a mortgage (so total contribution is $3,000). Regular contributions reduce your timing risk.
- Invest in commercial property, bonds/fixed-interest securities or other asset classes.
Which tactic (or combinations of tactics) listed above you employ depend on your financial position, risk profile and goals.
But these tactics are only possible for people that consistently spend less than they earn. As such, the first step to building wealth begins with good cash flow management. If you need help with any of this, please don’t hesitate to reach out to us.