Cashflow

What's the difference between Cashflow and an Income Statement?

Recently, a close friend asked: What is cashflow? I don’t get it. How is it different from my Income Statement?

This post will be geared towards a total beginner, a blank slate, and will offer links to a deeper understanding of cashflow.

First, let’s quickly review the context of finance.

In finance, there are 3 primary statements, which track our income, wealth, and cash:

  1. Income Statement

  2. The Balance Sheet

  3. Cashflow Statement

The income statement shows income - expenses = net income.

The balance sheet shows assets - liabilities = net equity/worth

The cashflow statement shows the fluctuations in your cash based on the influences from your income, expenses, assets, and liabilities.

As you can see the cashflow statement is the bridge linking between the income statement and the balance sheet.

You have some assets (currencies/cash, commodities, equities, and/or bonds), you also have some liabilities (student loans, credit cards, personal loans, etc.). This information is tracked in your balance sheet. Notice cash sits here as an asset.

You also have a salary you earn every month from work you preform, or alternative income sources from various work preformed, or maybe you own an asset which pays you regularly, then you spend some of that income, or all of it on your life’s needs and wants. This information is tracked in your income statement.

However, the pile of cash you posses changes and fluctuates over time based on two separate set of activities which are not accounted for in the same statement. So, how do we account for the changes in cash from expenses as well as debt repayments, or purchasing of assets/ income from assets as well as income from an employer? The answer is the Cashflow Statement.

The Cashflow Statement shows you how your cash is changing over time, based on the use cases: Income, Expenses, Assets, Liabilities.

There are 3 components to a cashflow statement:

  1. Cashflow from Operating Activities = Income Statement

  2. Cashflow from Investing Activities = Linked to Assets

  3. Cashflow from Financing Activities = Linked to Liabilities

If you have no Assets and no Liabilities, then your Income Statement is your Cashflow Statement. However, if you’ve taken out and are repaying any loans, if you’ve been investing in assets/ receiving payments from assets; then the cashflow statement is critical for your understanding of how your cash position is fluctuating and for what specific reasons.

In order not to overwhelm, and keep this simple, we’ll end here.

For further understanding, cashflow formula, cashflow patterns follow these links:

Making Sense of Cashflow for an Individual

Thinking of cashflow for an individuals differs from the traditional logic for corporate cashflow in the following ways:

  1. 99% of individuals do not/should not use accrual accounting.

  2. Thus, only the direct cashflow calculation method applies to individuals.

i.e. Accrual accounting, and the indirect cashflow calculation method should be avoided when applied to individuals.

What does this mean?

First, this means that an individual’s accounting system should operate on a cash basis, meaning records should be made when transaction take place (i.e. not when they are scheduled). Second, when calculating cashflow in the direct method, one should simply replace/equate the Income Statement to the first section of the cashflow statement, which is cashflow from operating activities.

The 3 components of a cashflow statement are:

  • Cashflow form Operating Activities = Income Statement

  • Cashflow form Investing Activities = Linked to Assets

  • Cashflow from Financing Activities = Linked to Liabilities

The changes in the cash position based on these 3 components, i.e. the delta between the starting balance and the ending balance is the individual’s cashflow.

Moreover, an individual can have one of 3 cashflow patterns:

  1. Employment -> Taxes Deducted -> Payout/Deposit -> Expenses -> Repeat. (no material balance sheet interaction)

  2. Employment > Taxes Deducted -> Payout/Deposit -> Expenses -> Liabilities and possibly some Asset purchases. Repeat. (balance sheet interactions are centered around liabilities, maybe assets)

  3. Assets -> Income -> Investing -> Liabilities -> Expenses - Taxes on remaining balance. Repeat. (emphasis on assets and income).

For an overview on personal cashflow go here: https://www.fullpowerfinance.com/cashflow

For an example of how to calculate your cashflow statement, linked to the other two financial statements: https://www.fullpowerfinance.com/statements

If you don’t understand any of this, start here:

https://www.fullpowerfinance.com/new-blog/what-is-cashflow

DESIGNING YOUR RETIREMENT INFRASTRUCTURE

Retirement centers around two primary concepts: Assets & Cashflow.

“You have to build your asset base”

&

“Liquidity has to be your primary focus in the long run”

Are you ready to seriously start thinking about your 'Retirement'? If so, you're in the right place. Simply put, 'retirement' is a term we use to describe a state in which someone doesn't need to work for money. This term essentially describes a person of any age, who sets their financial life up to be able to have/do whatever they want with their time irrespective of money as a need for covering their basic necessities.

Typically speaking, this retired someone is out of the labor force and over 65 years of age. However, more and more people are discovering the simple fact that 'retirement' is hackable, it can be engineered and implemented with relative ease at any stage in life. What does that mean? It means folks in their 40's, 30's, and even in their 20's are retiring. They are not retiring in the traditional sense of course. They simply figured out how to generate enough cashflow through their investments, to be able to afford not to have to work for money alone. This doesn't mean they don't work anymore, far from it, it means they get to work on what they want to work on, and they get to decided when they do so. It means they have full control over their time. They get to decided their schedules. They get to decided where they want to live on the globe. They get to decide for themselves, they choose who they work with, and what they get to work on, they are not bound to employment for mere financial reasons. These individuals are either working on passion projects, spending time with their family/friends, they are traveling around the world, or they are volunteering to help communities in need, or in some cases, all of the above. 

Sounds like a pretty good deal, no? Of course it does, but you’re here because you want to figure out how to get there. How to take full control over your time and money. 

If your goal is to free up your time, then you will need to first figure out how much money you’re going to need in order to do that. Many people assume they will need millions to retire. This is simply not true. What you need in order to retire successfully is Consistent CashFlow or a Large Pile of Savings, although the former is much more realistic to obtain than the latter. Instead of adopting the traditional model of accumulating employment savings and investing/lending these funds out to managers and markets to generate an income off dividends, what we are focusing on instead is the bypass of the employment phase, and the generation of consistent stream/s of month income to support our lifestyle. This means you should be thinking in terms of costs first i.e. the bottom up approach. Quick example: if you spend $2,000 on Rent or Mortgage, another $500 on food, another $250 on transportation, $700 for all other services = this means your monthly spend is $3,450. So, if you can figure out how to set up a system (or several systems) that generate this amount of cash every month, without you having to spend a lot of time maintaining them, then you can effectively, retire. Your needs will be met, and you can spend your time doing whatever it is you want. 

You: ok, I'm in, I get it. But how do I do it? What's the recipe? 

1. Passive Income - Many people figure out how to make money with out spending a lot of time on it consistently by setting up businesses and other income streams that are semi-automatic. The idea is simple: you put up all the work needed UP-FRONT (this means you bust your ass until the job is done), and then whatever business you create runs automatically or with minimal maintenance. Then you get to sit back and collect on your hard work.  We have seen so many different kinds of entrepreneurs doing this in so many different ways: RealEstate, Stock Trading, Small Business, Online Markets, Dropshipping, and the list goes on and on. Spend the time on developing your income streams, and you will be rewarded accordingly, you will have enough to cover your needs, and most importantly, you will have time. 

2. Investment Dividends - We cannot emphasize this point enough. Always invest your money! When you have some left over, don't buy that new car! put the money to work instead! Invest in your future self. Investing in stocks, ETFs, private businesses, cryptocurrencies, etc, etc, etc. The best ways to grow your wealth over time is to let your money work for you through investments, the sooner you can start the better. Investing is an essential practice in making your money make you money. When you do this well, you receive dividends, as well as capital gains, which you can use to spend and/or re-invest. Anyone who wants to retire early will need to have a steady stream of dividends coming in, and in the long run, you want those cap gains to balloon to the moon ;) 

3. Slash Expenses - Live like your a college student. Yes, you can do it, get rid of the car, the cable, the truthfully unnecessary excess. Just cut the crap and cut the costs. If you can't complete this basic move the hard truth probably is that you don't want it bad enough. We'll even take it to the point of canceling Netflix (check out popcorn-time...), yes, get rid of the all fat, you need to slim your finances up if your going to be nimble and flexible. All the excess "fat" get invested. 

4. Housing - Here's the deal, wether you rent or paying off a mortgage, your housing costs are probably 30% to 60% of your monthly expenses. In order to retire this is the #1 expense category you need to control. Move to another country if need be, get this cost eliminated or cover it with you Passive Income, but under no circumstances can you continue to bleed your cashflow on housing. In most all cases, if you can solve this piece of the equation then your gonna be able to retire with ease. Own your house outright, yes, we said it. Build yourself a tiny house. Move to a place where your living expenses are dirt cheap until you build up your cashflows (there are many regions in Europe where life is super cheap and you can live well, Asia is also filled with comfortable options for a good life on the cheap). The bottom line is that housing is your biggest expense, and you need to be able to not have to worry about this cost if your going to retire at any age. 

5. Digitize - track all of your finance with a P&L and a Balance Sheet.

Great! You got this far! Now one more step to consider and implement:  

Doing all this takes time and effort, you must be consistent, deliberate, and at times relentless. Be realistic. This will not happen over night, so you need a game-plan, set something super basic up, and above all you must keep yourself accountable. 

Food for thought: