To reach both short term and long term financial objectives, an understanding of annual cash flow is necessary. To accomplish this, it is important to have some type of annual budget. I have seen very detailed budget’s where every expense is tracked in detail and very broad budgets broken down by general categories. Both can work, but I would suggest each must have the following.
A budget starts with statement of gross income. This is gross income before pretax deductions such as retirement plan contributions or health care. For self-employed individuals, it is after business expenses.
From gross income deduct pretax deductions such as health insurance and retirement plan contributions through payroll deduction such as contributions to a 401-k Plan. For self-employed, deductions would be self-employed retirement plan or health insurance deduction.
The balance remaining would be gross taxable income. From this amount deduct estimated income taxes including state, federal and social security taxes. Keep in mind, this is an estimate of the actual taxes expected to be paid in the year, not the amount withheld from pay checks for employees or quarterly estimates for self-employed.
The remaining number is the gross spendable income. This is the actual amount of cash you have to live on or spend in a year. This breaks down into three separate categories.
- Annual contributions to savings and investments. This is separate to any pretax contributions to qualified retirement plans.
- Fixed expenses which include mortgage or rent, utilities, insurance premiums, loan payments which include credit card statements that are not paid off at the end of the month.
- Variable expenses which include food, clothing, entertainment, travel, etc. Essentially, this is living income with one exception.
The exception is if at the beginning of year, a household has a zero-card debt from the previous year and at the end of the year, there is $5,000 of credit card debt, then essentially the household is financing variable expenses or lifestyle with debt. This is different than buying a new car and financing the purchase with a low interest loan. Increasing credit card debt means the household is spending more that the household is making and unless corrected, will lead to serious negative financial consequences.
Once the budget process has been completed, the information determines the household’s ability to meet financial objectives.
Ultimately, if a household needs additional cash flow to reach financial objectives, the additional cash flow will normally come from one and/or the other of the following: Increasing annual income or decreasing expenses. This will be addressed in additional blogs.