A pivotal step in the financial planning process is cash flow analysis. As mentioned in my personal financial management post, cash flow is everything. If you have already gathered all of your financial data and created your financial planning statements you have everything that you need to start this portion of your financial plan. By the end of the cash flow analysis you should have a great idea about how your cash flow situation impacts your ability to achieve your goals and objectives, and what you can change in order to change your financial future.
Cash Flow Projections
Projecting your future cash flows illustrates how your long-term financial situation is impacted by your current financial behaviors. What this boils down to is understanding what the future might look like if you stay on your current path. Cash flow projections are a key step in measuring the gap between where you want to be and where you are now.
At this point, if you have your statement of cash flows (budget) in a spreadsheet you are well ahead of the curve. Projecting your baseline cash flows into the future is only a matter of assuming that your income, expenses, savings and investments will continue to increase and decrease based on their historical trends or other financial planning assumptions. So to do this, extend your current budget out to a reasonable time period, a common time period is when you and your spouse are 95-100 years old.
Incorporating Goals and Objectives
Once you have extrapolated your current income, expenses, savings and investments over a relevant time period, its time to incorporate your future goals and objectives. While assessing your cash flow projections begin to adjust your future income and expenses based on your desired lifestyle. You can start by determining your expected retirement age. Once you have that age and year, you should assume that you will no longer receive a paycheck and erase that part of your income.
In addition you can also assume that you will be able to draw from social security at that time thus you will need to account for that new source of income in your cash flow projections. In addition to retirement, your cash flow projections should also incorporate other goals such as when children attend college, major purchases (houses, vehicles, etc.) and job promotions. These changes will have a large impact on your future income and expenses.
Scenario Based Cash Flow Analysis
Once we have calculated our current financial situation and incorporated our financial planning goals and objectives, it's a common occurrence that we find that we do not have enough cash flow to accomplish all of our goals. This is also the point in time when we realize that in order to obtain financial freedom and the lifestyle that we want, we have to make some sacrifices.
The benefit to having your financial projections in a spreadsheet is that you can perform “what if” analyses. In order to do this take some of your current expenses like entertainment, vacations or other discretionary items and reduce the amount you are expected to spend on them. What happens to your savings and investments? Can you accomplish any more of your goals if you reduce your expenses?
Create a few scenarios and measure the impact on your financial plan, this is how you can improve the prospects of your financial future.
Measuring your current and future cash flow situation will help you gain an understanding of what you will need to do to accomplish your goals. When it comes to financial planning, there is nothing more powerful that understanding the gap between where you are and where you want to be.