Chapter 6
Cash Flow Planning
1
Chapter Goals
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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.
Overview
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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.
Overview, cont.
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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.
Cash Flow Planning and Current
Standard of Living
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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.
Cash Flow Planning and Current
Standard of Living, cont.
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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.
Reasons for Savings
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Let’s consider eight motives for savings:
The Pure Life Cycle Motive: To provide monies to
even out differences in earnings over time.
The Investment Motive: To take advantage of
investment opportunities that can make achievement
of our financial goals easier.
Downpayment Motive: To provide monies for the
down payment or full purchase of longer-lived assets
such as durable goods or educational expenditures.
Precautionary Motive: To provide a fund to cover
future uncertainties such as fluctuating income,
sickness, inflationary effects on expenditures, etc.
Reasons for Savings, cont.
5.
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7.
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Improvement Motive: To sacrifice today so that your
future lifestyle can improve.
Independence Motive: To fund sufficient money to be
able to be financially independent after working to a
certain age.
Bequest Motive: To accommodate funds to provide
for nonhousehold members whether they are
children, friends, relatives, or charities.
Hoarding Motive: The ability to accumulate
investments with no intention of converting them into
purchases in the future.
Reasons for Savings, cont.
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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.
Simple Structural Approach
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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.
Provide Motivation: “The Buckets
Approach”
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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.
Eliminate the Option to Spend
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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.
Reduce Temptation
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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.
Minimize Discomfort
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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.
Other Reasons for Not Saving
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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.
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.
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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.
Purchasing Power
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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.
Emergency Fund
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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.
Emergency Fund, cont.
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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.
Liquidity Substitutes
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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.
Liquidity vs. Marketability
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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.
Liquidity vs. Marketability cont.
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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.
Constructing a household budget
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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.
Establish Budgeting Goals
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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.
Establish Budgeting Goals cont.
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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.
Decide on the Budgeting Period
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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.
Calculate Cash Inflows
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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.
Project Cash Outflows
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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.
Project Cash Outflows, cont.
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Percentage breakdown of expenses by income:
Item
Average annual expenditures
Food and beverages
Housing
Apparel and services
Transportation
Health care
Entertainment
Personal insuarance and pensions
Life and other personal insurance
Pensions and Social Security
Other*
Complete reporting of income
Total
Lowest
Middle
Highest
complete
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20
20
reporting percent
percent
percent
100%
100%
100%
100%
14%
18%
15%
12%
32%
35%
32%
31%
4%
5%
4%
5%
19%
17%
20%
17%
6%
7%
7%
4%
5%
4%
4%
6%
11%
3%
9%
15%
1%
1%
1%
1%
10%
2%
8%
14%
9%
11%
9%
10%
*Other includes personal care products and services, reading, education, tobacco products
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and smoking supplies, miscellaneous and cash contributions.
Source: Adapted from Bureau of Labor Statistics, Consumer Expenditure Survey, 2002
Compute Net Cash Flow
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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.
Compare Net Cash Flow with Goals
and Adjust
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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.
Review Results for Reasonableness
and Finalize Budget
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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.
Compare Budgeted with Actual Figures
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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.
Financial Ratios
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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.
Current Ratios
Currents Assets
Current Ratio
Current Liabilities
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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.
Emergency Fund Ratios
Liquid Assets
Emergency Fund Ratio
Total Monthly
Household Expenses
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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.
Operating Ratios
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Operating ratios measure the overall costs of the
household and its components as a percent of total
income.
Total Nondiscretionary
Costs
Nondiscretionary Cost
Percentage
Total Income
Total Discretionary
Costs
Discretionary Cost
Percentage
Total Income
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Operating Ratios, cont.
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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.
Operating Ratios, cont.
Total Nondiscretionary
Costs
Total Discretionary
Costs
Total Operating
Percentage
Total Income
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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
Payout Ratio
Discretionary
Expenses
Discretionary Capital
Expenditures
Discretionary Payout
Percentage
Cash Flow before
Discretionary Expenses
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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.
Savings Percentage
Net Cash Flow
Targeted Savings
Change in Debt
Gross Savings
Percentage
Total Income
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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.
Chapter Summary
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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.