How to keep a firm grip on cash flow and preserve your wealth

In the latest of a series of articles, former lawyer and City money man Peter Alcaraz discusses the 'NAN' gap and explains how to keep track of your cash flow.

Peter Alcaraz read law and economics at Durham University and spent 24 years advising small and mid-sized companies on mergers, acquisitions, IPO's and fund raisings, first as a lawyer and for the last 20 years in corporate finance. At the age of 46 after reaching 'O' he left city life to write, study, travel and spend more time with his wife and two daughters. His first book, The Wealth Game - an ordinary person's companion was published in 2016 and has become a staple amongst wealth managers, business schools and private individuals wishing to develop their personal finance skills. 

• How you can achieve financial freedom more quickly

• How to calculate your real net worth

• How to calculate your total future needs and retire early

Comparing your net worth and needs gives the first significant pointer in the wealth game. Your net-assets-to-needs 'NAN' gap, will be a shortfall or a surplus. At this stage, it's indicative only, a back-of-the-envelope calculation using rough-and-ready estimated figures. Nevertheless, to get this far, you have looked at some of the most important components in your personal financial health story. The result, fun or frightful, is less important than the process of getting here.

Over time, I'll look further at these concepts and add refinements so that you can better assess whether you have reached O.

Meanwhile here are four important principles to remember about the NAN test:

1. Numbers are 'capitalized' and expressed in today's money value.

The NAN test compares your net assets today with your total future needs, also expressed in today's money value. It is a snapshot position of assets and liabilities at a point in time and quite different from (and much easier to do than) traditional cash flow forecasting.

Future asset returns and cost inflation are all put to one side for now. They are important but can be dealt with later in a simple and more effective way. The exact timing of future income and needs also has a bearing and again can be considered later.

2. Your net asset value is calculated after tax and selling costs have been deducted.

Tax is a real cost to your wealth and therefore needs to be factored in, whether it has been paid yet or not. All assets included in your net worth should be valued after selling costs and capital gains or other taxes payable have been deducted.

Let's say that you own an investment property worth £150,000 that, if you were to sell today, would incur a capital gains tax liability after reliefs and allowances of £10,000 and transaction expenses of £5,000. You should record its value as £135,000 (£150,000 − 10,000 − 5,000).

The logic behind this approach is that your needs, together with the resources you set aside or generate to meet them, should be directly comparable. A need of £100 cannot be fulfilled by an asset worth £100 if the net proceeds of its sale after tax are only £80.

Add up the gross value of all your owned assets, and calculate a net of tax and sale expenses total, using current rates, reliefs, and allowances applicable to each. It is reasonable to factor in some tax planning, such as phased sales to utilize annual exemptions, rather than assume complete liquidation at once.

3. The NAN gap includes you and your dependants.

O is a personal target, so the test is oriented to you as an individual, but if you provide financially for a partner, spouse, children, parents, or anyone else, you must include their costs in your needs total.

4. It's a relative test.

The entire premise of O is matching your resources to your needs. Absolute totals, large or small, are meaningless in isolation.

How Does Cash Fit In?

The Problem

Many people mistake cash flow for wealth and confuse the two. They think that having cash makes them wealthy, and they behave accordingly.

The problem is that when they spend their cash, it is swapped for something else. If they buy an appreciator, wealth is preserved and should grow, but if they opt for a depreciator, value will waste away over time, and for a consumable, value is lost immediately. You might think it self-evident that spending choices affect wealth, but this simple truism is widely overlooked or forgotten, as you can see from consumer debt, which continues to balloon.

Plenty of ordinary people have high net cash flow for a phase of their lives. They can live well, consuming and pleasing themselves without a financial care in the world. This cash may be a new experience, novel and exciting, and perhaps follows years of doing without. They may treat being 'asset light' as a virtue and enjoy freedom from responsibility. This is no way to prosper in the wealth game.

Pleasure, such as it may be, is sustained only by the cash fuelling it, and at some point, for the ordinary person, this cash flow will stop; the job or career will end. Without the porridge pot of wealth, the only course is to down-scale and live simply on whatever money can be eked out from earnings or state benefits. This may be exactly what the player always wanted and foresaw, but on the other hand, it may not. The point is they won't have any choice in the matter.

The Way Forward

You should be clear as to the nature of cash flow. It is like the element of water, fluid and moving. It is the fuel for wealth creation, since without it, you cannot buy or develop assets. At the first sight of it, you should put as much of it to work as you can.

Second, it is a by-product of wealth, because assets, whether productive appreciators or productive depreciators, generate income, and all assets deliver cash on sale.

Cash flow is not wealth itself but a measure of solvency, and it is not the same as cash, the asset that can be exchanged for something else. It is measured over a period of time, rather than at a moment in time, like net worth. A person's net cash flow is £x over a week, £y over a month, and £z over a year. Measured weekly or monthly, it may dip into negative territory as the timing of income receipts and payments vary, but over a period of time, it should be positive. A negative cash flow is unsustainable and, if maintained, leads to insolvency.

It follows that to succeed in the game, you need to keep a close grip on cash flow and take care not to trade wealth for short-term lifestyle.

How do you measure it?

Personal net cash flow is the difference between the money you have incoming after tax and your outgoing cash measured over a period of time.

Incomings include all cash or money that comes into your possession in the chosen period, even if it is advanced for work yet to be done or as a loan to you. Tax is deducted at current rates after applicable reliefs and allowances.

Outgoings are all payments out of any kind, except for tax that has already been deducted from the incomings side.

The result is a surplus, a deficit, or a zero balance.

When I refer to surplus cash flow, I mean the cash available to grow your wealth so any cash available to save, invest, service mortgage interest and repayments for a property and so on.

This is the game currency.

Keeping track

Unlike net worth, which can lie inert and hidden until discovered through your balance-sheet calculation, cash flow has a dynamic life of its own and is unavoidable. It constantly ebbs and flows, enabling you to pay your way or not. However wealthy you are, your cash needs must be satisfied, and money must be in the right place at the right time. The decision is not whether you measure or monitor it but how?

Measuring cash flow over a past period involves fact-finding to trace all the incomings and outgoings that happened during that time. This can be laborious or even impossible,depending on the state of your record keeping. If done properly, the result is an accurate picture of how much money has come in and how much has been paid out—a story of your financial activity.

Forecasting cash flow over a future period is a completely different and much more worthwhile exercise. You are no longer bound by history, and although some spending is non-discretionary, like rent or mortgage interest, utility bills, and insurance, much is partly or wholly up to you to decide. The past is only a guide.

The first exercise is like doing a postmortem, while the second is a health assessment, an eating and exercise plan for someone still living. Medical or financial health history is useful, but only up to a point. What matters is how the patient is going to behave and fare from now on. You should devote your energy to planning and forecasting future cash flows. In doing this, refer to past spending only to support your assumptions. Once you are living the plan, check at intervals to see how accurate your guesswork is, and refine it where necessary.

Having chosen your review period, decide on the level of detail and approach. Your own style and circumstances will determine this, as well as how much time you wish to commit. If you are living on the edge of your means and feel the need to police your spending rigorously, you may opt for prescriptive, hands-on planning with constant forensic review. If not, a more relaxed and less time-consuming method can suffice.

I have seen a number of approaches:

Cash in hand

There is no listing or measuring of any ins or outs—simply look at what's in your wallet or bank to decide whether you can afford something or not.

This primitive approach can work if you have all the cash you need, but in all other cases, it leads to money controlling you and your life. It is a blunt instrument that can leave you short of funds and is to be avoided.

Micromanagement

This is usually a weekly or monthly record of all incomings and outgoings by category, reconciled to bank balances—a comprehensive and detailed audit of your or your family's ongoing and projected financial activity. This can be diced and sliced to show categories of income and expense, percentage contributions, and ratios. As time passes, you can compare actual performance against your forecasts, and it builds into the kind of record a finance director keeps.

Avoid this kind of exercise if at all possible. It is very time consuming and takes a lot of pleasure out of the process of living, like being electronically tagged and monitored or having to report daily to a parole officer. Unless you are a pathological recidivist, there is likely to be a better, more effective way.

Further dangers exist with over-analysis and excessive detail. This can take on a life of its own so that users become a slave to its requirements and lose the will for independent thought. Second, the often spurious accuracy creates a false sense of security and overreliance, an “it must be right because the spreadsheet says so” mind-set. Finally, you risk getting lost and not seeing the wood for the trees— you may be unable to get a general understanding of the situation because you are too worried about the details. Simple but powerful actions or strategies may be overlooked as you burrow through the minutiae and complexities.

Annual, half-yearly, quarterly, or monthly look forward

For this option, you might prepare a summary output page for the chosen period with sources at the top, uses at the bottom, and a calculated difference between the two. It picks up known or expected cash inflows and outflows. Supporting pages in the spreadsheet can include more detail and feed into the summary page.

All players should know approximately how much it costs them to live for a year, both at a minimum (if times are hard) and living with a few luxuries, as well as how much they generate after tax from all sources. Keep these numbers, particularly costs, in your head.

If your sources comfortably exceed your outflows, you may choose to drop the sources section and just keep a schedule of expenses over the year to keep tabs on the overall shape and scale of your spending. The performance of your assets is picked up elsewhere, and there is no merit in calculating something if you don't need to.

Manage by feel

As an evolution of the last method, you can, over time (and assuming no major changes in circumstances), develop a sense of the numbers on an annual basis without needing to do the calculation at all. If a major financial change takes place, such as new job, the start of school fees, a new mortgage, or retirement, you can return to an annual look forward for a year or two until you have the numbers in mind again.

This is a marvellous point to reach, as it is highly efficient and economic. You can shift your attention to the more valuable exercise of acquiring and stewarding assets and building net worth, which will further enhance your cash-generation capability. It is like sailing without a wind indicator or telltales, which are essential for novice sailors or for absolute precision in a race but not for a capable helmsman sailing for pleasure, guided by the feel of the wind on their face.

Event-specific management

However accurate your feel is, there will still be occasions when you need to shift money into the right place, perhaps to pay for a major purchase or event. Funds may be on timed deposit or tied up in assets that need to be sold. A certain amount of advance planning can't be avoided.

In choosing which one or combination of these to use (or any other variation), ask yourself what you are trying to achieve from the effort, and limit your objectives to the simplest and most useful. There are other, simpler ways of identifying and policing overspending. If you think it's happening, then it probably is, and rather than trying to deal with the problem by recording it in a spreadsheet, why not just stop doing it?

How much can you generate?

Here's a frightening calculation… Let's say that your after tax salary is £50,000 pa and that you work for a full 40 years. You generate £2,000,000 compared with the 40-year needs total of £2,950,000 calculated earlier. Now factor in some career breaks or interruptions to earnings… How on earth can you square this, let alone reach O in say 30 years?

The only way, short of winning the lottery or inheriting, is to own productive appreciators that generate cash and grow in value. Soon, I'll offer a plan for this. Meanwhile, how can you generate more surplus cash flow? Read the next edition to find out...

Peter Alcaraz is a freelance contributor and not a direct employee of interactive investor.