Cash flow means spending less than you earn

One idea I’ve mentioned regularly on The Simple Dollar is that of “cash flow.” It’s an accounting term that refers to the movement of money into or out of a business or project over a specified period of time.

I really like to use the idea of “cash flow” to look at the state of a family’s finances. Over the course of a month or a year, the “cash flow” of a household can tell you a lot about how the family is doing financially.

Here’s an example of what I’m talking about.

Let’s say that in December 2013, a family brings home $6,000. During that same month, the family spends $5,500 on their bills and other family expenses, both necessary and otherwise. This leaves the family with a cash flow of +$500.

First of all, a positive cash flow is a good thing. That means the family is spending less than they’re bringing in. At least some of their income is sticking around, going into savings or investments or toward debt repayment.

Now, let’s say that, out of that $5,500 they spend each month, the family spends $2,000 solely on debt repayment. They have a mortgage and a couple of student loans.

As soon as they pay off one of those debts, that amount they’re spending on debt repayment will go down. The family will have fewer monthly bills and thus their cash flow should theoretically improve. After all, if they already have a cash flow of +$500, paying off a debt with a monthly bill of $200 should improve their cash flow to +$700, right?

That’s one of the biggest principles of cash flow: elimination of monthly bills – particularly in the form of eliminating debts – is one of the easiest ways to improve your family’s cash flow. Every monthly bill you can reduce or eliminate will improve your family’s cash flow.

This is the big reason why I often suggest people pay off their debts before beginning to invest. Paying off debts is the most direct route to a better monthly cash flow for your family.

Why is a bigger monthly cash flow so good, though? I look at it as being something of an “emergency fund” for life.

Let’s say you’ve worked hard and reached a point where you’re actually spending $2,000 less than you bring in each month. You have no mortgage and no other debts. In that situation, imagine a job loss. You likely have some savings but, more importantly, even after the job loss, your monthly bills are low enough that you’re not going to intensely struggle with them for a while.

Let’s say you have a really interesting job opportunity sitting out there in front of you, but it pays $1,500 less per month than you’re making. If you’re spending everything you bring in – a cash flow of $0 – taking that job is impossible. If you’ve paid off your debts and you have a cash flow of $1,500 a month, then you can take that job without changing much of anything else about your life.

Cash flow gives you flexibility. It gives you protection against bad things in life. To me, it’s a wonderful argument in favor of getting rid of every debt you can as fast as you can, because those debt payments strangle your cash flow.

In the end, cash flow really comes back to that one key principle of personal finance: spend less than you earn. It’s just a different way of looking at that idea, one that really shows the value of getting rid of your debts.

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