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Chapter 6

Cash Flow Planning

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Chapter Goals

Apply cash flow analysis to household finance. Treat cash flow planning as a central activity in PFP. Utilize budgeting techniques effectively. Develop savings approaches. Employ financial ratios as an evaluation method.

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Overview

Cash flow planning underlies all major household decisions.

Often, weak cash flow arises from poor planning and control of expenditures.

All parts of a financial plan must incorporate cash flow considerations.

In this discussion we focus on current operating needs.

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Overview, cont.

The chapter’s planning objective consists of three parts: – To recognize the importance of cash flow to

achieving goals, – To learn how to identify savings problems, and – To establish what can be done in practical terms

to overcome these problems.

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Cash Flow Planning and Current Standard of Living

Cash flow planning: The scheduling of current and future cash needs to achieve household goals.

Examples of cash flow planning objectives:– Supporting a current life style. – Paying off credit card debt. – Saving for a vacation.

More sophisticated and long-term goals include reducing tax liabilities and planning for retirement.

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Cash Flow Planning and Current Standard of Living, cont.

Life styles vary significantly: – Some people live simply.– For others, identities and goals require spending

on visible signs of achievement and status. We have a choice between spending and saving.

– To spend is to add to our standard of living today. – To save is to provide for future needs.

While most have no difficulty spending, many have difficulties in generating the amount of savings they require.

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Reasons for Savings

Let’s consider eight motives for savings: 1. The Pure Life Cycle Motive: To provide monies to

even out differences in earnings over time.2. The Investment Motive: To take advantage of

investment opportunities that can make achievement of our financial goals easier.

3. Downpayment Motive: To provide monies for the down payment or full purchase of longer-lived assets such as durable goods or educational expenditures.

4. Precautionary Motive: To provide a fund to cover future uncertainties such as fluctuating income, sickness, inflationary effects on expenditures, etc.

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Reasons for Savings, cont.

5. Improvement Motive: To sacrifice today so that your future lifestyle can improve.

6. Independence Motive: To fund sufficient money to be able to be financially independent after working to a certain age.

7. Bequest Motive: To accommodate funds to provide for nonhousehold members whether they are children, friends, relatives, or charities.

8. Hoarding Motive: The ability to accumulate investments with no intention of converting them into purchases in the future.

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Reasons for Savings, cont.

People may intend to save but find themselves with no money left at the end of the pay period.

We next consider several ways of overcoming this problem.

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Simple Structural Approach

Treat savings as another expense. Write a check to savings each period at the same time that fixed monthly expenditures are paid.

Alternatively, have cash automatically wired to a separate savings or investment account when the payroll check is deposited.

Develop a budget – a detailed list of income and expenses with planned expenditures limited to accommodate a desired amount of savings.

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Provide Motivation: “The Buckets Approach”

People find it easier to save when they have a concrete goal in mind.

Therefore, a slush fund for total savings is not as effective as separate accounts (“buckets”) for each need.

For example:– A bucket for retirement– A bucket for children’s college education– A bucket for a down payment on a house.

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Eliminate the Option to Spend

Place money in accounts that have penalties for early withdrawals such as pension accounts, tax deferred annuities, or life insurance policies.

Alternatively, contract for a house and undertake large monthly mortgage payments.

Aside from potential appreciation on the home, the savings will come from accelerated pay-down of debt, which leads to increased equity in the house.

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Reduce Temptation

Stay away from stores that result in greater spending than needed.

Carry credit cards only for planned expenditures and for vacations.

Try to use cash as much as possible.

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Minimize Discomfort

Some are reluctant to cut back on current spending because they perceive it as resulting in a decline in their standard of living.

They are more agreeable to savings based on future increases in income.

Therefore, success in saving can occur by having people save a fraction of the extra money obtained from raises before the new money enters the spending stream.

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Other Reasons for Not Saving

People may fail to save because: – They do not have a strong ability to visualize the

long-term future or to estimate future revenues or current savings needs correctly.

– They prefer greater spending today rather than in the future.

– They feel that their life span is uncertain and, therefore, assured spending today provides more pleasure.

– They value simpler, less costly pleasures when they retire and want more material ones now.

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Formal and Informal Budgeting

Budgeting: A method of planning current and future household cash flows to determine needs and adhere to desirable allocations of resources.

There are two types of budgeting techniques:Informal budgeting Involves less detailed ways of planning, sometimes as

simple as just thinking about household down payment on a car.

Formal budgeting When budgeting is formal and reflects all categories of

household expenditures, usually in the form of a document, it is said to be a household budget.

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Formal and Informal Budgeting, cont.

The budget is a type of pro forma cash flow statement with a purpose.

Because little can be done about fixed expenses, budgeting tends to focus on discretionary items.

In theory, saving is a mechanical process. In reality, human behavior intervenes. We know that

many people have trouble saving money. Detailed written budgets are often a means of

establishing structure for those who need it. The budget becomes a detailed framework for the

future.

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Purchasing Power

Purchasing power: The amount of goods and services a fixed sum of money will buy.

Purchasing power risk: The risk of having your money decline in what it can buy over time due to inflation.

In making projections of salaries and household costs, inflation must be taken into account.

To be conservative some planners hold salaries level in making projections. This can lead to distortions.

Often, the solution is to express revenues and expenses in current dollar and then, increase these items where appropriate each year by the inflation rate.

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Emergency Fund

The ability to turn assets into cash quickly without a high transaction cost or loss of principal is important, as cash flow projections are subject to the risk of unexpected circumstances.

Often, such cash comes from a liquid emergency fund set up specifically for that purpose.

For example: – One may unexpectedly be laid off in our jobs.– One may receive a lower than anticipated bonus. – Costs may rise due to health issues.– Costs may rise due to extensive repairs to the house

or car.

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Emergency Fund, cont.

The amount placed in an emergency fund depends on the following considerations:– The degree of risk the household faces.– The availability of borrowing alternatives. – Projections of future free cash flow to be

generated.– The amount of debt outstanding.– The availability of other assets such as stocks

and bonds.

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Liquidity Substitutes

Households often desire to place their funds into higher earning assets or can choose to spend a greater sum today.

As an alternative they have liquidity substitutes. Two types of liquidity substitutes are:

– Debt: For shorter term emergencies, cash can be accessed through credit card debt, while larger cash resources needed for extended periods of time can be generated through bank debt.

– Marketable securities: Publicly traded financial assets for which a current market value can be determined that are typically easy to sell in order to raise cash.

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Liquidity vs. Marketability

Liquidity: The ability to turn an asset into cash quickly at a reasonable transaction cost and without loss of principal.

For example, money market funds would be liquid but bonds would not be, as investment losses on sale of bonds are possible.

Marketability: The capacity to find a seller or buyer of an asset at its current value.

An asset can be marketable but not liquid. For example, stocks and bonds have buyers and

sellers at any time and thus are marketable, but are not fully liquid since losses on sale are possible.

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Liquidity vs. Marketability cont.

A traditional home in a popular location is marketable because a buyer can generally be found at a fair price, but it isn’t fully liquid since it will take time to find a buyer and to close on the house, and it may also require time for the seller to move to another residence.

Liquidity and marketability are both relative terms: Assets may be highly liquid or marketable, or fairly illiquid and nonmarketable or they can be somewhere in-between.

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Constructing a household budget

The following are the steps required to construct a household budget:– Establish budgeting goals – Decide on the budgeting period – Calculate cash inflows– Project cash outflows– Compute net cash flow– Compare net cash flow with goals and adjust – Review results for reasonableness and finalize budget – Compare budgeted with actual figures

Let’s consider each in turn.

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Establish Budgeting Goals

Immediate goals when establishing a budget may include:– Targeting savings for a particular expenditure – Saving for larger investment purpose

However, a budget may be established because the household is in a negative cash flow situation and debt is accumulating. The goal then is to reverse the cash drain and repay the debt.

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Establish Budgeting Goals cont.

The objective of the budget is to:– Assure that the household generates enough

cash to meet household operating needs and over time

– To provide resources for emergency funds if current assets are insufficient.

By providing hard numbers to household members, the budget can also help to reduce inefficient spending.

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Decide on the Budgeting Period

Budgets can be weekly, bi-monthly, monthly or annually.

The period can follow the natural income and spending cycle which can be linked to how often a paycheck is received and when bills are paid.

Many people pay bills on a monthly basis. For review purposes, this period of time represents a balance between too frequent and too little examination of actual versus intended results.

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Calculate Cash Inflows

Cash inflows for budgetary purposes are typically the amounts received from paychecks.

Monies received from investments and nonrecurring sources should be displayed in a separate section or otherwise noted.

Cash from investments is for a separate purpose and including nonrecurring inflows can distort the figures.

To simplify matters after-tax inflows received from pay checks are often used.

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Project Cash Outflows

Outflows should be separated into nondiscretionary and discretionary items.

Checkbook status or software should be used as a guide for past figures whenever possible.

When that is not possible, a significant miscellaneous category should be used for projections for unanticipated expenses including those for unforeseen circumstances.

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Project Cash Outflows, cont.

Percentage breakdown of expenses by income:

Source: Adapted from Bureau of Labor Statistics, Consumer Expenditure Survey, 2002

Total complete reporting

Lowest 20

percent

Middle 20

percent

Highest 20

percentAverage annual expenditures 100% 100% 100% 100%Food and beverages 14% 18% 15% 12%Housing 32% 35% 32% 31%Apparel and services 4% 5% 4% 5%Transportation 19% 17% 20% 17%Health care 6% 7% 7% 4%Entertainment 5% 4% 4% 6%Personal insuarance and pensions 11% 3% 9% 15% Life and other personal insurance 1% 1% 1% 1% Pensions and Social Security 10% 2% 8% 14%Other* 9% 11% 9% 10%

*Other includes personal care products and services, reading, education, tobacco products

and smoking supplies, miscellaneous and cash contributions.

Item

Complete reporting of income

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Compute Net Cash Flow

Net cash flow is simply projected cash inflows minus projected cash outflows.

If investment income and nonrecurring items have not been separated yet, adjustments should be made to get a fairer comparison.

The resultant figure should be net cash flow after adjustments, the amount that truly represents your cash generated during the period.

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Compare Net Cash Flow with Goals and Adjust

Projected cash flow figures should be compared with goals.

When the figures show a shortfall, determine how the shortfall is to be eliminated.

Three ways to eliminate a shortfall: – Find additional income.– Cut back costs.– Alteration in goals.

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Review Results for Reasonableness and Finalize Budget

Assess the reasonableness of projections. – Do they seem realistic? – Do they take into account inevitable nonrecurring

expenses? The outcome may be an adjustment in projections

and in some instances further cutbacks in expenses. At this point the budget can be finalized.

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Compare Budgeted with Actual Figures

Results seldom come out exactly as projected. Where there are differences the reasons have to be

ascertained. Four common reasons for differences are:

– Impulse purchases, – Income that differs from projections, – Unusual occurrences, and – Gifts.

The insights developed as a result of this step should be incorporated in future projections.

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Financial Ratios

Financial ratios are a way of gauging the current state of the household’s assets and operating activities.

Frequently, figures from both the balance sheet and cash flow statement are used to develop the ratios.

Comparisons are made with absolute standards of good performance and with relative results for that particular household over time.

We now take a closer look at selected liquidity ratios and operating ratios.

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Current Ratios

The current ratio measures your present resources available to pay current debts.

This ratio should exceed 1.0 x. Having less could represent an inability to pay debts when

due. The ability to borrow money through credit card purchases

and to delay payment on existing card debt has somewhat reduced this concern.

Current Ratio

Currents Assets

Current Liabilities

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Emergency Fund Ratios

The emergency fund ratio measures how many months of living expenses can be supported by available liquid assets.

Often a ratio of at least 3x is called for signifying that 3 months of cash or other liquid, less volatile securities are available.

The greater the uncertainty for income and expenses, the higher the ratio.

Emergency Fund Ratio

Liquid Assets

Total Monthly Household Expenses

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Operating Ratios

Operating ratios measure the overall costs of the household and its components as a percent of total income.

Nondiscretionary Cost Percentage

Total Nondiscretionary Costs

Total Income

Discretionary Cost Percentage

Total Discretionary Costs

Total Income

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Operating Ratios, cont.

Nondiscretionary cost percentage provides the proportion of day-to-day overhead costs to total revenues.

Our goal is to reduce the nondiscretionary percentage over time

The lower the percentage, the greater the amount available for discretionary costs and savings and investment. Discretionary costs represent the benefits of our household efforts.

Assuming appropriate savings, the lower the percentage of household fixed costs and the higher the percentage of optionable expenses, the greater your satisfaction and standard of living.

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Operating Ratios, cont.

The total operating cost percentage indicates how much of household revenues are being spent today on nondiscretionary and discretionary costs.

It can serve as a control on expenses and as a guide to the amount available for capital expenditures and savings.

The lower the percentage, the larger the amount available for these items

Total Operating Percentage

Total Nondiscretionary Costs

Total Discretionary Costs

Total Income

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Payout Ratio

Cash flows before discretionary expenses measures the percentage of available cash flow that is actually expended on all leisure outlays.

A high payout percentage can reflect a desire for a higher standard of living today as opposed to improved household efficiencies and a higher, more secure standard of living in the future.

Discretionary Payout Percentage

Discretionary Expenses

Discretionary Capital Expenditures

Cash Flow before Discretionary Expenses

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Savings Percentage

The savings percentage indicates the total combined percentage of total income that is being put away for future needs.

The amount expended to pay off debt is considered savings while an increase in debt reduces the savings rate.

Gross Savings Percentage

Net Cash Flow Targeted Savings

Total Income

Change in Debt

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Chapter Summary

Cash flow planning is often performed near the beginning of the financial planning process.

Available cash flow allows financial planning. Savings for future needs can be difficult for some and budgeting

techniques can help bring about acceptable savings rates. There are a variety of methods that can facilitate savings

including a simple structural approach providing motivation, eliminating an option to spend, reducing temptation, and minimizing discomfort.

Financial ratios can provide an objective assessment of specific segments of a household’s financial condition.