Monday, May 23, 2011

The Importance of a Truly Postive Cash Flow

 Many folks bandy about the term  "positive cash flow " without understanding what it really means.  They think that if the cash is flowing, all is good.  Usually, just the opposite is occurring.

I noted in the importance of net worth, that it is a good idea to keep track of your net worth over time.

You may see the term "cash flow" bandied about by some economists and financial gurus.  And your friends may use the term - incorrectly - to self-justify their poor economic choices.

For example, a foolish friend may say, "I was going to buy a new Honda, but decided to lease it instead, as this improved my cash flow".  What does he mean by that?

Well, what he meant was that, in the very short term (month-to-month) he spends less, on a monthly basis, and thus has more cash left over for spending on other things (we could hope he uses that money to save, but hey, he leases cars, so what are the odds of that?).

Of course, while this may show a short-term improvement in cash flow for 36 months, it's that 37th month that kills you.  You see, the fellow who bought instead, has a car, free and clear.  While the fellow who leased, is walking home from the dealership, unless he leases another car.  There is no free lunch, and when you pay less per month, by leasing, you get less on the long run.

But having a positive monthly cash flow is important, to be sure.  But many folks often don't calculate this properly and then fail to understand how they end up deeper and deeper in debt, even though they have a good "cash flow".  Their problem is, the cash is flowing right out the door.

For example, Suzie takes home $2000 a month, after taxes.  She spends $800 a month on rent, $250 a month on her car lease, $100 a month on her car insurance, $150 a month on her utility bill, $100 a month on her cable bill, $110 a month for her smart phone plan, and $50 a month making the minim payment on her credit card.  This leaves her $440 a month to live on, which is not a lot.  From her perspective, however, she has a "good cash flow" as she is making her payments every month with some "money left over".

Of course, the problem is, she is running up credit card debt.  Since she can't realistically live on $440 a month to pay for her groceries, meals, clothes, and other expenses, she charges a lot of things, and slowly, her credit card debt increases over time.

But since the "minimum payment" on the credit card is only a few dollars a month (at first), Suzie can make all of her payments and congratulate herself on "keeping current" on all her bills.

But the credit card debt keeps increasing, and while Suzie can make the payments, she is getting further and further into debt.

And this process can go on for five, ten, and even fifteen years.  You see, Suzie gets a raise and makes more money, so they extend her more credit - and she can pay it off.  Or Suzie gets a home equity loan, which pays off the credit card debt, but just shifts the debt to 30-year terms.  And the credit card, within a few months, starts to accumulate a balance and within a few years, she is back where she started - only worse.

A true positive cash flow means not just that you are paying your bills and have a little left over.  No, rather it means that every month, you not only have money left over, but that your net worth is increasing and your debt load is decreasing.  If you have money left over at the end of each month, but your net worth is decreasing and/or your debt load is increasing, you do not have a truly positive cash flow.  Rather, you are just borrowing from the future, more and more, to give the appearance of balancing the budget today.

And don't feel too bad - the U.S. Government is doing the same thing.  But while the Government can just raise taxes or print more money, you and I do not have those options.  Somewhere, sometime, debts have to be paid off.  And if you keep accumulating debt into your 40's and 50's, you will end up very poor in your 60's and 70's.

Turning this around is not hard to do, from a monetary point.  But from a psychological one, it can be devastating.   After all, you "deserve" 500 channels of cable and a new leased car, right?  And you can't be seen in last year's clothing styles, or anything less than a $100 haircut.  Right?

But getting over the spending habit is the hardest part to turning around the cash-flow and net worth situation.  Once you realize that spending money is not wealth - but accumulating money is - then you can stop the madness of spending more than you are making.

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