The importance of cash flow management
overview
Core to any financial plan is effective cash flow management. Its importance cannot be overstated, and once in place, will result in the efficient use of one's financial capital through:
Income being directed to its most important uses,
Expenses being met as and when they fall due,
Surplus cash not going to waste, and indeed earning the maximum risk adjusted rate of return possible,
Shortfalls between income and expenses being forecast allowing sufficient time to undertake mitigating action, and
The use of credit, where appropriate, to its full effect whilst simultaneously minimising the associated interest cost.
Although it was prepared a few years ago, this piece by Macquarie presents a nice simple introduction to the importance of cash flow management in one's overall portfolio. The key messages of cash flow management remain timeless, with the products and mechanics of execution the only aspects that evolve through time. You will notice that towards the end of the report, reference is made to the Macquarie Cash Management Account. This provides a good option for a cash management hub. Other options that provide a similar feature set are those offered by UBank and ING Direct. Each have their advantages and disadvantages depending on one's needs. For further information see their respective websites:
Note that Financial Actuality is not affiliated with Macquarie Bank, UBank or ING Direct or any of their associates. We do not receive any remuneration from them. Those are clean links to the respective websites and by selecting them no benefit accrues to Financial Actuality.
we are here to help
If you find the idea of reading through product disclosure statements somewhat off-putting, feel free to contact us for a confidential one-on-one personalised discussion. Irrespective of how little (or how much) you may have, we are willing to provide suggestions for your situation. In a sense, the size of the money being managed is less relevant than how it is being managed. Our focus is on the how, and the size will follow naturally.
One of the main missions of Financial Actuality is financial literacy and education – to pierce through the complex veil, or uncover the actuality behind the appearance as it were, that is often presented in a manner designed to confuse. Indeed, given the degree to which most people are time poor, even choosing the correct bank account can appear to be a herculean task, which unfortunately can mean that either it never gets done or the wrong one is selected. In turn, how much less is being devoted to optimising one’s whole financial structure!
The importance of sound financial decisions and structure is critical, ideally starting from a young age, given the compound nature of the subject. Wise decisions compound into further positive outcomes, both in terms of the growth of wealth via compounding but also the practice and habit of good financial management will influence further smart decision making. Ultimately, efficient personal financial management becomes a mindset and way of thinking that will feed on itself.
Similarly, bad decisions compound into even larger ones. The earlier that you set your course on the right heading, the more time it has to grow and prosper. The later one sets that course; there is less time to correct. Opportunity cost is a major theme in finance, and the most precious resource of all, time, is something that indeed bears a very high cost if misused.
We want to change this and provide inspiration and motivation to all, irrespective of their socioeconomic status and portfolio size. The principles underlying sound financial management apply at all stages of your personal finance journey, and need not be something that is only considered by those who enjoy a high-net worth. Everyone deserves to understand these concepts and sometimes all they need is a helping hand. Financial Actuality aims to educate people in the world of finance - be it high finance and financial markets or matters relating to personal finance. We enjoy assisting others to navigate what can be an overwhelming minefield of options and to ultimately empower them to make decisions that best suit their needs.
Self-discipline
Credit cards can be a contentious issue. Many have been taught to believe that the use of credit (or debt) is somehow an inherently bad thing and should be avoided at all cost. While it is certainly true that accruing a large amount of debt through overspending on depreciating assets (and subsequently poorly managed resulting in large interest costs) is a major source of concern, the use of debt in a disciplined manner can be of great benefit for those who know how.
It has often been said that in order to control one’s spending, it is best to use only cash. The theory goes that by physically handing over your hard earn money there is a strong psychological association with what you are departing with – it forces one to really consider the purchase as it were. This is intuitively logical to understand and for some it will largely define their behavioural finance profile.
However, if one genuinely requires feeling the physical loss of cash to prevent an ill-advised purchase, there are bigger issues at hand – and even more so when there is seemingly no deterrent to spend regardless of the means by which it is undertaken. To emphasise this point further, something to keep in mind with any discussion around managing one’s finances, and ultimately planning towards financial independence, is the fundamental driving principle of self-discipline. It underlies the whole schema of efficient and effective personal financial management. Without it, either at the outset or over time, the whole plan will fail - irrespective of its apparent soundness.
So influential is this attribute that if one was to change nothing with respect to how they manage their cash flow, investment allocation, effective tax structure via the use of trusts/company’s, debt load etc., but addressed their own behavioural self-discipline when it comes to spending money, they will already have made significant progress towards sound financial management. To wit, one can earn $10 million dollars per year, but if their annual spend rate is $12 million they will not reach financial independence.
A simple analogy that can be sighted is that of virus protection on one’s computer. Virus protection software, firewalls and malware blockers do indeed help to reduce the likelihood of infection – however, if a user repeatedly opens emails or downloads programs that pose a high degree of risk, well then those safeguards are only effective up to a point.
If you read nothing else on this website and the only take away is that you start to consider your own spending habits, especially when it comes to items that depreciate in value and in reality only possess a very short-term gain to your utility, then its creation will have been worth it!
Credit Cash
With a view towards the disciplined use of one’s own financial resources, when using a credit card each dollar spent should be a dollar that you can afford to spend. Even though the transaction is facilitated via the use of credit, it should be viewed as spending one’s own cash - because it actually is! However, due to there being an intertemporal difference between purchase/consumption and actual payment, this can psychologically mean there can be a dissociation resulting in forgetfulness and lack of importance on the need to satisfy payment. The link between the item purchased and consumed 5 weeks ago and the bill in front of you today can appear as two different things. But do not fall into that trap - be self-aware. Hence, rather than thinking of it as a credit card think of it as credit cash. Used in this way, a credit card will be a valuable tool in your financial product suite toolkit.
It should be said that if you would be influenced to spend more merely because you have access to credit, then use a debit card as any potential gain of the credit card will be offset by extra spending that would have otherwise not occurred. That is to say, its use would be tantamount to false economy in the extreme.
The two financial benefits emanating from the use of a credit card (as opposed to non-financial benefits such as it being an efficient statement of account for your expenses etc.), relate to:
The cash money that would have otherwise been used to undertake the transaction earning a return elsewhere up until the due date of the statement; and
Any associated rewards that come from its use (cash back, frequent flyer).
As you can see, if your expenditure profile over the year is in no way influenced negatively by the use of a credit card, then in actuality it is paying you to use it. There is something inherently satisfying about being paid to do what you would do anyway – a good motto for life in general.
Efficient Autonomous Cash Management
In essence, one should structure their outward cash flow such that over the course of a month, all expenses are paid via the credit card and to ensure that no interest is incurred, a direct debit set up such that the full outstanding balance is paid on the due date. Any monthly, quarterly, semi-annual or annual payments for recurring bills should have their payment made by automatic direct debit to the credit card itself – this ensures that you do not forget to pay but also means that you need not spend time having to make the payment as it is all done for you. This is also the reason behind having the credit card balance paid via direct debit. Even though internet banking has made undertaking such activities somewhat easy, once you have experienced fully automated (or close to) cash flow management, you will never look back.
Associated with the use of a credit card is the central cash hub. This cash hub is at the core of your cash flow management structure and facilitates all eventual income and expenditure flow. The nature of this cash hub will vary depending on the specific circumstances, but the aim is the same regardless – excess cash is earning the maximum interest rate possible, whilst expenditure is being made via a credit card that is rewarding you for using it, and when payment for that account is required it occurs seamlessly without (or minimal) input from the individual.
Case Studies
Everyone’s individual/household circumstances are different but in general most fall into one (or potentially more) of the following broad categories:
Holds debt via a mortgage on the primary place of residence,
Holds debt via an investment loan (be it through investment property or margin loan), and
Holds no debt and has pure savings.
Let’s look how each of these could structure their affairs to ensure efficient cash flow management.
Holds debt via a mortgage on the primary place of residence
Assuming a variable home loan with an offset account, the central cash hub in this case would be the offset account. Given the interest rate differential between home loan and savings account rates, on a post-tax basis it is unambiguously advantageous to hold cash in the offset account as it earns your loan rate.
All salary, dividend and other income should be directed into the offset account.
A credit card is used to facilitate all expenditure, including recurring bills that have been set up such that they are direct debited from the credit card.
For each statement period, the full balance owing is direct debited on the due date from the offset account.
Holds debt via an investment loan (be it through investment property or margin loan)
In cases where the main debt for the household is via an investment loan, it is similar to the first example in that you will want to have all cash offsetting (or residing in e.g. forming equity in the margin loan) the loan balance as the interest being charged on that will be higher than what you would be able to earn in a savings account. In this case specifically, however, as we have an investment loan it is less certain as to whether it has been structured as a variable or fixed rate loan.
In the case of variable, then the set up is exactly the same in the first case study above. The added complication with a margin loan, however, is that although all your cash should be placed in there, it does not have the technical ability to function as a cash hub – for instance margin loan accounts cannot readily be direct debited to satisfy monthly credit card bills. The only transactions permitted will generally be inward/outward cash flows into a linked account.
For instances of a fixed rate investment property loan or a margin loan, therefore, the use of an additional savings account cash hub is required. The three banks referenced at the top of the page each provide accounts that will be able to function as this cash hub. They each have their advantages and disadvantages so please refer to their websites to see which would suit your particular needs. Please also feel welcome to contact us should you wish to discuss.
All salary, dividend and other income should be directed into either the offset account or savings account cash hub.
A credit card is used to facilitate all expenditure, including recurring bills that have been set up such that they are direct debited from the credit card.
For each statement period, the full balance owing is direct debited on the due date from the offset account or savings account cash hub.
Holds no debt and has pure savings
In many ways this is the easiest situation to organise, and will be often faced by those in retirement.
A savings account cash hub should be opened with all salary, dividend and other income directed into this account.
A credit card is used to facilitate all expenditure, including recurring bills that have been set up such that they are direct debited from the credit card.
For each statement period, the full balance owing is direct debited on the due date from the savings account cash hub.
Everyone’s circumstance will be unique but this has shown the general theme of efficient cash flow management and how it may be undertaken. It can take a little work to initially arrange these structures but once in place, they will show their benefits in no time. The most efficient cash flow structures actually make you money whilst being easy to manage - because at the end of the day its all about gaining more time to undertake the things we value the most.
We encourage you to consider your own circumstances and whether any improvements can be made.
Should you wish to discuss further please contact info@financialactuality.com
Addendum
Some points to note:
To tailor an efficient structure for any one person or household requires knowledge of the specifics as to their their unique set of circumstances, but the above provides an overview of three common situations found in the majority of cases. Above all else, it aims to have the reader consider their own cash flow management.
There are times when a fixed rate mortgage is used for the primary place of residence. In those cases, there is often a fee associated with extra repayments and there is no offset account available. In those cases a savings cash hub as described in the second and third case study should be used. Fixed rate mortgages tend to be advantageous in cases where the individual wants cash flow certainty or where it is funding an investment property and the interest cost is tax deductible. For the primary place of residence, unless cash flow certainty is a must, a variable rate mortgage with offset tends to be the best way for to go for most.
In some instances, depending on the spending habits or structure of the individual/household in question, other products may be superior to using a credit card for all expenditure. For instance, in the past ING Direct had once offered for a period of time 2% cash back on Visa payWave transactions (that is to say, those transactions less than $100 and paid for via the Visa payWave technology). Often this will produce a higher dollar return than using a credit card with an associated reward program for those particular transactions. Where such offers are available, we would always suggest investigating their suitability to one's situation - just keep in mind that there is often a degree of added logistical overhead in using such a structure relative to that of solely relying upon a credit card. Accordingly, one would have to assess whether the extra time required to manage such a setup is offset by the dollar gain. Nevertheless, the aim of this piece is to provide an overview of cash flow management and how it can be structured. For more personalised suggestions, please feel free to contact info@financialactuality.com