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- Chapter 6
Cash Flow Planning
1
- Chapter Goals
Apply cash flow analysis to household finance.
Treat cash flow planning as a central activity in PFP.
Utilize budgeting techniques effectively.
Develop savings approaches.
Employ financial ratios as an evaluation method.
2
- Overview
Cash flow planning underlies all major household
decisions.
Often, weak cash flow arises from poor planning and
control of expenditures.
All parts of a financial plan must incorporate cash
flow considerations.
In this discussion we focus on current operating
needs.
3
- Overview, cont.
The chapter’s planning objective consists of three
parts:
– To recognize the importance of cash flow to
achieving goals,
– To learn how to identify savings problems, and
– To establish what can be done in practical terms
to overcome these problems.
4
- Cash Flow Planning and Current
Standard of Living
Cash flow planning: The scheduling of current and
future cash needs to achieve household goals.
Examples of cash flow planning objectives:
– Supporting a current life style.
– Paying off credit card debt.
– Saving for a vacation.
More sophisticated and long-term goals include
reducing tax liabilities and planning for retirement.
5
- Cash Flow Planning and Current
Standard of Living, cont.
Life styles vary significantly:
– Some people live simply.
– For others, identities and goals require spending
on visible signs of achievement and status.
We have a choice between spending and saving.
– To spend is to add to our standard of living today.
– To save is to provide for future needs.
While most have no difficulty spending, many have
difficulties in generating the amount of savings they
require.
6
- Reasons for Savings
Let’s consider eight motives for savings:
1. The Pure Life Cycle Motive: To provide monies to
even out differences in earnings over time.
2. The Investment Motive: To take advantage of
investment opportunities that can make achievement
of our financial goals easier.
3. Downpayment Motive: To provide monies for the
down payment or full purchase of longer-lived assets
such as durable goods or educational expenditures.
4. Precautionary Motive: To provide a fund to cover
future uncertainties such as fluctuating income,
sickness, inflationary effects on expenditures, etc.
7
- Reasons for Savings, cont.
5. Improvement Motive: To sacrifice today so that your
future lifestyle can improve.
6. Independence Motive: To fund sufficient money to be
able to be financially independent after working to a
certain age.
7. Bequest Motive: To accommodate funds to provide
for nonhousehold members whether they are
children, friends, relatives, or charities.
8. Hoarding Motive: The ability to accumulate
investments with no intention of converting them into
purchases in the future.
8
- Reasons for Savings, cont.
People may intend to save but find themselves with
no money left at the end of the pay period.
We next consider several ways of overcoming this
problem.
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- Simple Structural Approach
Treat savings as another expense. Write a check to
savings each period at the same time that fixed
monthly expenditures are paid.
Alternatively, have cash automatically wired to a
separate savings or investment account when the
payroll check is deposited.
Develop a budget – a detailed list of income and
expenses with planned expenditures limited to
accommodate a desired amount of savings.
10
- Provide Motivation: “The Buckets
Approach”
People find it easier to save when they have a
concrete goal in mind.
Therefore, a slush fund for total savings is not as
effective as separate accounts (“buckets”) for each
need.
For example:
– A bucket for retirement
– A bucket for children’s college education
– A bucket for a down payment on a house.
11
- Eliminate the Option to Spend
Place money in accounts that have penalties for
early withdrawals such as pension accounts, tax
deferred annuities, or life insurance policies.
Alternatively, contract for a house and undertake
large monthly mortgage payments.
Aside from potential appreciation on the home, the
savings will come from accelerated pay-down of
debt, which leads to increased equity in the house.
12
- Reduce Temptation
Stay away from stores that result in greater spending
than needed.
Carry credit cards only for planned expenditures and
for vacations.
Try to use cash as much as possible.
13
- Minimize Discomfort
Some are reluctant to cut back on current spending
because they perceive it as resulting in a decline in
their standard of living.
They are more agreeable to savings based on future
increases in income.
Therefore, success in saving can occur by having
people save a fraction of the extra money obtained
from raises before the new money enters the
spending stream.
14
- Other Reasons for Not Saving
People may fail to save because:
– They do not have a strong ability to visualize the
long-term future or to estimate future revenues or
current savings needs correctly.
– They prefer greater spending today rather than in
the future.
– They feel that their life span is uncertain and,
therefore, assured spending today provides more
pleasure.
– They value simpler, less costly pleasures when
they retire and want more material ones now.
15
- Formal and Informal Budgeting
Budgeting: A method of planning current and future
household cash flows to determine needs and
adhere to desirable allocations of resources.
There are two types of budgeting techniques:
Informal budgeting
Involves less detailed ways of planning, sometimes
as simple as just thinking about household down
payment on a car.
Formal budgeting
When budgeting is formal and reflects all categories
of household expenditures, usually in the form of a
document, it is said to be a household budget.
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- Formal and Informal Budgeting, cont.
The budget is a type of pro forma cash flow
statement with a purpose.
Because little can be done about fixed expenses,
budgeting tends to focus on discretionary items.
In theory, saving is a mechanical process.
In reality, human behavior intervenes. We know that
many people have trouble saving money.
Detailed written budgets are often a means of
establishing structure for those who need it.
The budget becomes a detailed framework for the
future.
17
- Purchasing Power
Purchasing power: The amount of goods and
services a fixed sum of money will buy.
Purchasing power risk: The risk of having your
money decline in what it can buy over time due to
inflation.
In making projections of salaries and household
costs, inflation must be taken into account.
To be conservative some planners hold salaries level
in making projections. This can lead to distortions.
Often, the solution is to express revenues and
expenses in current dollar and then, increase these
items where appropriate each year by the inflation
rate.
18
- Emergency Fund
The ability to turn assets into cash quickly without a
high transaction cost or loss of principal is important,
as cash flow projections are subject to the risk of
unexpected circumstances.
Often, such cash comes from a liquid emergency
fund set up specifically for that purpose.
For example:
– One may unexpectedly be laid off in our jobs.
– One may receive a lower than anticipated bonus.
– Costs may rise due to health issues.
– Costs may rise due to extensive repairs to the
house or car.
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- Emergency Fund, cont.
The amount placed in an emergency fund depends
on the following considerations:
– The degree of risk the household faces.
– The availability of borrowing alternatives.
– Projections of future free cash flow to be
generated.
– The amount of debt outstanding.
– The availability of other assets such as stocks
and bonds.
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