This will be the third part of our ongoing series on personal financial statements. The topic this time is your personal cash flow statement. If you’ve read our previous entries on making a personal income statement and creating a personal balance sheet, you already have a good system in place to keep you financially healthy. In fact, once you understand how to create a cash flow statement and link all three statements together, your personal accounting system will likely be more sophisticated than most small businesses.
As usual, Aiman is here to guide us through the process of creating a personal cash flow statement. What's up with Aiman, anyway? The last time we joined him, he had just created his personal balance sheet and calculated his net result. Not a very pretty sight, but he was definitely on track to recovery. He already knows where he is at financially (net worth) and where he is going (monthly net result) so what more could Aiman possibly want to know about his finances?
Actually, Aiman could use some extra financial insight, because he is planning to get married! With whom you might wonder? Quite surprisingly, Aiman and his girlfriend got back together after a few months. Apparently, Aiman’s love for his girlfriend trumps his love for financial health because his girlfriend still has the same endearing qualities as before. Anyway, a wedding is an important milestone with a financial commitment that should not be disregarded. After a long discussion, Aiman and his girlfriend expect to spend RM77, 000 on their wedding, which is planned to happen 5 months from now.
Aiman really wants this wedding to happen, but he is unsure if he can afford such a wedding. His income statement indicates that his months are profitable, but it does not give him any indication as to his cash balance. His income statements show a steady profit but his accounts have been rather low lately. He wants to know specifically if he will have RM77, 000 in 5 months’ time or if he needs to commit to a personal loan or more credit cards. A personal cash flow statement can be a great tool in this situation, let’s look at how it works.
What is a cash flow statement?
The Cash flow statement looks pretty similar to an income statement but it is actually quite different. Where the income statement is more concerned with profitability, the cash flow statement is primarily about liquidity. Its function is to show you if you have enough cash to keep paying your bills in the short term.
Normally, cash is real money that you can actually touch. In this article, when we refer to cash balance we mean your current accounts. For the purpose of the cash flow statement, your current account can be considered cash because it is the most liquid form of asset that you have. Actual cash money can be treated in two ways. If you generally carry a lot of real cash around, you can add it to your current account balance to calculate your total cash balance. If you don’t, then just skip it, because it would be impractical for you. Your current account is the basis of the cash flow statement.
The cash flow statement is about actual money going in and out of your wallet or account. Unlike the income statement, you don’t need to allocate your expenses to specific months, because what you are looking at now is WHEN you spend the money. For example, if Aiman prepays for a 5-month gym membership this month, his cash flow statement would show the complete amount as a cash outflow while his income statement would only show the amount that relates to that specific months as an expense.
This might be a difficult concept to grasp. With the cash flow statement, you always have to think about how it affected your cash balance, while with the income statement you want to show the most reliable picture of your profitability.
Imagine if you would record the whole gym membership payment in the income statement. Your income statement for the first month would show a lower profit than the next 4 months, even though nothing changed in your basic activities. Similarly, if you would record only parts of the payment in your cash flow statement, the statement would no longer show what actually happened to cash.
Cash is King
The cash flow concept is widely used by people, business and countries. For people, it can be used as a quick and easy way to predict your cash balance at any given time. For business, it is a mandatory part of the accounting cycle, with free cash flow being one of the most important financial performance indicators. Countries use the cash flow concept in the Balance of Payments, which is the countries’ record of incoming and outgoing flows of goods, services and capital.
A good phenomenon to demonstrate the importance of cash flow is a bank run. During a bank run, people lose confidence in a bank and consequently withdraw all their money from their accounts. The problem with this is that a bank never has enough money on hand to repay all accounts at once. Most of the deposits are reinvested in the form of housing loans, business loans and investment products to generate a return on the money they manage. The margin between this return and the interest on savings accounts is where the bank makes its money. However, people see this inability to repay as a confirmation for their lack of confidence and even more people will try to withdraw their money. This creates an almost inescapable downwards spiral of severe negative cash flow. The bank is forced to deviate from its standard business practice and has to start repaying massive amounts of money to customers. This makes the normal operation of the bank almost impossible and can drive the bank into bankruptcy, even if the bank is normally making a decent profit.
Afterwards, people will say: ‘’See? We were right to take our money out, they went bankrupt!’’ Which can be a false assumption, because the massive withdrawals could actually be the main cause of the bankruptcy. Almost any business would be forced into bankruptcy if they had to repay all their creditors at once. Short-term liquidity is very important in business and it is just as important to you.
Aiman is intrigued by the cash flow concept and is determined to add the cash flow statement to his already active statements.
By creating a cash flow statement, Aiman can see every transaction he has made this month that has affected his total cash. Aiman can use the cash flow statement as an effective budgeting tool that predicts his future cash balance. Let’s go through it step-by-step:
- List your total cash balance in your current account
- List all debit charges to all your accounts during your target month
- List all credit charges to all your accounts during your target month
- Divide your charges into handy categories
- Put everything together
You are free to determine categories for yourself that you deem useful. For the purpose of this example, we will use the official business classifications of cash flows. Accordingly, you could divide your cash flows into the following three categories:
Cash flow from operating activities
Any and all cash flows from your ‘operations’, which are your core activities. Your core activities are things that are essential to how you live your life. Any change in these activities is likely to have a large effect on your financial situation. Your main cash inflow from operating activities is usually your salary, while your main cash outflow is most likely rent or mortgage payments. Other common operating cash flows include:
- Groceries
- Lifestyle expenses
- ATM withdrawals that you cannot trace.
- Insurance payments
Cash flow from investing activities
Investing cash flows is money coming in and out, that change your lifestyle structurally and long term. The purchase of investment products, cars, and real estate can all be classified as investing cash flow. They have a longer effect on your finances but are not a part of your daily routines, which would fall under operational cash flow. Even the costs of Aiman’s wedding would fall into this category because it is not part of his normal routine. This is a very important category to focus on if you want to create long term wealth because it relates to the acquirement of assets.
- Investment products
- Real estate
- Cars
- Wedding costs
Cash flow from financing activities
Any and all cash flows resulting from debt obligations or credit commitments. Credit cards, personal loans, mortgages, interest payments all fall into this category. This category basically aggregates all the actual cash flow that occurs as a result of a transfer between your current account and your various debt products. If Aiman would take a personal loan to finance his wedding, the personal loan would fall into this category.
- Interest payments
- Debt repayments
- Transfers to savings accounts
- Transfers to retirement accounts
- Credit card repayments
- Personal loans
Let’s see how Aiman goes about creating his own cash flow statement. He first lists his initial and ending cash balances and all charges that happened during the last month. Your own current account list might be a lot longer but since this is just an example, we’ll keep it short and practical.
In the first row, we see Aiman’s current account charges, in the order in which they occurred. In the second row, Aiman has color-coded each expense to relate to either an operating, investing or financing activity. In the third row, he has then grouped those charges together. Again, you can choose any categories you want, as long as they make sense to you. Don’t be afraid to customise!
Let’s look at the list. Most of his charges are part of his daily routine or lifestyle expenses which means they are can be classified as operational cash flow. Aiman classified his clothing purchase as an investment cash flow because Aiman does not go shopping enough to call this purchase part of his routine. Additionally, the clothes were work related and he feels that they will add to his career progression. The interest and loan payments that he made this month have been classified as financing cash flow because they are related to the level of debt that he is servicing. His ending cash balance is RM491 higher than his starting cash balance. Although this is a good sign, an Income Statement is better suited to give you insights regarding profitability.
After that, he can formulate his first cash flow statement:
Cash Predictions
To determine if Aiman has enough for his wedding in 5 months, he has to do some further calculations. The next step is to predict future cash flow statements based the one he has already established. He could make his prediction more reliable by calculating average percentages over multiple months, but if his cash inflows and outflows don’t vary much month-on-month than using one cash flows statement is also fine.
His total positive cash flows are RM3,400, while his total negative cash flows are RM2,909. This means that his net cash flow for the month is RM491. (3400 – 2909) If his net cash flow for the month remains the same for the next five months his current account balance will be RM3,546 (1091 + 491*5). Aiman concludes what he already suspected, he is not going to able to afford the wedding just from his job alone.
Luckily he has some other options available. Next, to his current account, Aiman also has a savings account with RM5,000 in it. Additionally, his parents agreed to lend him RM20,000 for his wedding with 0 interest and he can borrow the rest with a personal loan. Looks like Aiman is getting his wedding after all!
A personal cash flow statement can be a useful tool if you want to extrapolate your cash flow into the future, just as Aiman did. If you have a better idea of how much money you will have in the future, you also have a better idea about how much you need to borrow. Go here to see the best personal loans for your particular needs.
You can also make a budget cash flow statement and compare that with your actual cash transfers at the end of the month. Comparing what you think you spend with what you actually spend can be very confronting and help you adopt healthy financial habits. However, if you do expect to have a short-term cash shortage in the near future, you can always get a credit card to give you more room. Find one to suit your specific situation here.
Now that you’re familiar with the income statement, the balance sheet and the cash flow statement, you can start to create your own accounting system. Each statement has a specific function but combined they give you an extremely holistic view on your finances that is truly invaluable.
- Use the Income Statement to determine if you are living within your means.
- Use the Balance Sheet to determine your net worth and get a clear picture of where you are at financially.
- Use the Cash Flow statement to see if you are able to pay your bills in the short term.
This brings us to the end of this series and our journey with Aiman. We hope you enjoyed reading about Aiman and financial statements, but most of all we hope that you were able to get value out of it. Keep in touch with our blog for more articles on personal finance, money saving tips and the best deals throughout Malaysia.
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About the writer
Jesse is a Guest Writer at CompareHero.my. A business student with a passion for finance and football, he is interested in new cultures and stepping out of his comfort zone.
CompareHero.my strives to empower Malaysians with financial literacy and the tools to make better financial decisions in life. Find and compare the best credit cards, personal loans and broadband plans on CompareHero.my today.
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