The key to a business’s success lies in its ability to effectively manage its cash flow. Businesses that strictly adhere to sound cash flow principles are always better positioned to weather storms and jump on opportunities to help them grow. What if you were to apply those same principles to your personal finances? If you were to manage your personal finances like a business, could you be better positioned to weather the storms, and, perhaps, jump on investment opportunities to make your net worth grow? It’s difficult to imagine you wouldn’t be; and the good news is you don’t have to be a CFO to make it happen.
Businesses generally have three different purposes for their cash flow: 1) to cover immediate cash needs which they would fund from the cash-on-hand account; 2) to cover ongoing operating expenses which would come from their working capital account; and 3) to save for future capital investments using their capital account. This way of allocating their cash allows them to manage each account according to specific guidelines with established budgets for each. To a great extent, all financial decisions are nearly automatic. Any changes to the guidelines or the budget would have to be made by the management committee during the annual planning process.
Viewed from a personal financial management standpoint, all a business really does is set up three buckets in which to allocate a portion of its cash, each with a specific purpose and in order of priority. The cash-on-hand account takes priority because it has to pay immediate expenses. Ongoing expenses are the next priority because it keeps the business running. If there is only enough cash to fund those two accounts, then there would be no funding of the capital account for now. Let’s see how this might work for your personal finances:
Your checkbook is your cash-on-hand account which is used to pay your immediate, essential expenses, such as food, housing, transportation, utilities, etc. The goal is to budget the account so that it has enough to cover these expenses for the month, and, if you manage to live under your means, anything left over can then be transferred to your working capital account.
Working Capital Account
Your working capital account might be a separate checking account, or maybe a money market account you use to cover non-essential expenses. These would be your lifestyle or leisure expenses, such as entertainment, travel, dining out, splurge or impulse purchases - all of the things needed to keep you and your family operating in the lifestyle to which they are accustomed. The more effectively you budget for and manage your cash-on-hand account, the more cash you will be able to allocate to your working capital account.
The one big caveat is that no funds should be available for non-essential expenses until you have fully funded your emergency fund, which should be held in a completely separate account.
Your capital account can be a savings account or investment account (separate from your retirement plan to which you are already allocating a portion of your earnings) for the excess cash flow from your working capital account. These accounts can be earmarked for specific goals, such as buying a larger home, college education, starting a business, or simply for wealth accumulation. Of course, the better you do at managing your working capital account, the more funds you will be able to allocate towards building your wealth. Studies show that the key to building wealth is to live below your means; meaning, the less you spend on non-essential expenses, the greater your capacity for building wealth.
The key to managing your finances is to simplify; and the best way to do that is by breaking your budget down into smaller, more manageable pieces, or buckets which are managed according to their objective or purpose. Your spending objectives will be more clearly defined, and, by having separate guidelines for each account, your financial decisions are practically made for you.
Are you looking for more help with managing your finances? Our calculators are a great place to start!