FINANCIAL STATEMENTS: Introducing Your New CFO - PLANNING FOR TODAY - Simple Money: A No-Nonsense Guide to Personal Finance - Tim Maurer

Simple Money: A No-Nonsense Guide to Personal Finance - Tim Maurer (2016)

Part II. PLANNING FOR TODAY

Chapter 8. FINANCIAL STATEMENTS: Introducing Your New CFO

WHY do I need to read this chapter?

Every company has a CFO—the Chief Financial Officer—in charge of stewarding the firm’s finances. Their job is to keep an eye on the company’s assets, liabilities, and cash flow, and to report the state of the company’s financial standing to the board.

How do you think the CFO would be received at the board meeting if, when asked to report, he said, “Ah, uh, well, money comes in, money goes out … it all seems to be working, uh, pretty well.”

I think the CFO would likely be dusting off his résumé.

Well, guess who the de facto CFO is for you and your household?

That’s right. It’s you. And since you’re also lead board member, I’m curious—how would you grade yourself as CFO?

Don’t worry. If you didn’t get rave reviews, I’ll give you all the training you need in the next 10 minutes to make you a splendid new CFO of You, Inc. All you need to do is master three personal financial statements:

· Balance Sheet

· Cash Flow Statement

· Budget

In this chapter, we’ll discuss the single most important indicator of a successful financial plan, your cash flow mechanism. Whether you make $10,000 or $10 million per year, it is your successful handling of cash flow that will be the driving force of any financial success, or failure.

So, how do you manage the flow of money into and out of your household? And more importantly, how do you intend to do so in the future?

Balance Sheet

The Balance Sheet takes a picture of your present financial situation. It lists your assets (the stuff you own) and liabilities (whatever you owe). Hopefully, when you subtract the latter from the former, the result is a positive number—your net worth, as in the example on the next page.

At its simplest, the overriding objective is to keep that net-worth number marching upward, with special attention paid to the items we highlighted in the Enough Index (chap. 6).

The Balance Sheet has a special influence due to the otherwise manic nature of the way we collect our most important financial information. Instead of separate statements strewn about for each checking, savings, mortgage, credit card, loan, brokerage, 401(k), IRA, and Roth IRA account, in the Balance Sheet we finally see everything in one place. Elegant simplicity.

You can access a Balance Sheet template like this at www.simplemoney.net/tools. This template is designed to emphasize elements that bump our Enough Index northward. I think it’s important to update this document at least annually, but please know that it is possible to update too often. Because your assets invested in “the market” are in a constant state of flux, checking your balances too often can cause Enough-sapping anxiety. (Much more in chap. 9 on investing.)

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There are some excellent online tools and apps that will automate your balance sheet, but only as long as you have online access to your financial accounts and are willing to enter your usernames and passwords. Personal Capital and Mint are two tools I recommend. Personal Capital, in particular, offers a very sleek Net Worth feature that updates in real time.

Oh, and did I mention that both of these tools are free?

Cash Flow Statement

The Cash Flow Statement is an examination of our past spending, categorically. It’s very difficult to project what we would like to spend in the future if we don’t know what we’ve spent in the past. An example of a personal cash flow statement is shown on the next page.

As individuals, we tend to avoid cash flow analysis for some obvious reasons. For starters, it can be very tedious, especially if your household, like mine, is an active contributor to the nation’s economic output. It’s amazing how many and how various the transactions a family of four with a dog and turtle can produce. So, you have to set yourself up for success. If you try to review all of your household expenses on a monthly or quarterly basis, you’ll almost certainly be overwhelmed by the scope of the project. If, however, you review your expenses weekly, it becomes a much more manageable task. Instead of feeling like getting a root canal, it’s more like brushing your teeth. Tedious, yes, but manageable. The Rider can get bogged down by too much information, but he or she loves feeling in control.

The other big reason we avoid cash flow analysis is that it reminds us of how we fail. The Elephant hates feeling like a failure, and will therefore avoid opportunities to be reminded of such. I review our household spending weekly, and then in more detail at the end of the month. I don’t know that we’ve ever had a month when we didn’t overspend in some category. Fortunately, perfection is not the goal, and it helps to set the Elephant’s expectations properly. Like baseball, cash flow analysis is an exercise in mistake management, not perfection.

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Budget

We accommodate our imperfection by anticipating our inevitable failure in the form of budgeting. When I ask people, “Do you budget?” many of them say, “Yes, of course.” If I probe further, I discover that what they call budgeting is merely tepid cash flow analysis. I’ll hear, “Yes, when I pay my credit card bill, I glance down through my transactions.”

Deliberate review of our past spending is the most time-intensive step in cash flow analysis, but it is in budgeting—forecasting a future spending plan—where we either succeed or fail.

“Shoot, we spent too much on groceries again last month” is a helpful observation only if you choose to spend less in the future or increase the grocery budget. Either one works, but it’s your decision. That emphasis on choice is how Jesse Mecham, the creator of YNAB (YouNeedABudget.com) helps motivate his many followers. Here is the simple, but effective, four-step YNAB methodology:

1. Give every dollar a job.

2. Save for a rainy day.

3. Roll with the punches.

4. Live on last month’s income.

“Where did all of my income go?” is an often-heard lament. It feels almost as if there’s a force outside the household that gobbles up whatever excess cash exists. By giving every dollar a job, you’ll know where it went, and thus have an opportunity to better direct it.

By saving for a rainy day, we do two things. We start by shielding ourselves from situations we’d label emergencies. But if that was its only purpose, Mecham could’ve just said, “Expect the unexpected.” A rainy day fund can just as well be used to fund spontaneity.

Rolling with the punches helps to set our expectations properly. When we expect surprises as a matter of course, we don’t freak out (as much) when they happen. We keep the Elephant from veering way off track. And when we live off of last month’s income, we’re no longer living paycheck to paycheck. This breathing room is the signature YNAB strategy, and it is an incredibly effective builder of Enough.

I asked Jesse Mecham, “So, what do you think about giving people guidance on how much they should spend in each category?” For example, here are some common rules of thumb you may have heard around the watercooler or from the preceding generations of your family:

· Spend no more than 25 percent of your net household income on housing, whether renting or owning.

· Spend no more than 15 percent on food.

· Limit entertainment spending to no more than 10 percent.

· Limit vacations to no more than 5 percent.

· Spend no more than 5 percent on auto loans.

In response, Mecham told me, “I honestly don’t think those ‘rules of thumb’ are too useful. You move inland by 600 miles and everything changes.” While he acknowledged that rules of thumb like this could be helpful either as starting points or for the purposes of refining objectives, every household is going to be different.

While it may be helpful to consider a host of different and thorough analytics that recommend certain allocations to various budgetary categories, the real reward in budgeting comes from tailoring a cash flow system to your own values and goals (chaps. 2 and 3).

Nudging Your Way to Financial Success

Economists Richard Thaler and Cass Sunstein coauthored the book Nudge, which has broad application for everything from international public policy to setting your monthly coffee budget. One of their more potent insights is that default options are incredibly powerful. When you crack open a new phone or computer, the setup process offers several opportunities for customization, but the path of least resistance is found in the default options. Not surprisingly, that’s what most of us choose.

The most effective budgeters establish default options for themselves. If saving 10 percent and giving 10 percent are priorities, they simply default to living off 80 percent of their income. Everything else follows.

The power of setting defaults for household cash flow is strengthened even more by automating these defaults. You can automate more than you think—likely over 90 percent of your budget. Once you’ve automated as much of your budget defaults as possible, you can more freely enjoy spending whatever excess cash remains. Guilt free.

Consider the values-driven, goal-oriented, automated budget on the next page. Note that after funding your saving and giving priorities, your monthly expenses are broken down into Fixed Expenses—those that remain constant, like your mortgage and car payment; Predictable Expenses—those that tend to remain in a range, like groceries and utilities; and Discretionary Expenses, like money for eating out and going to the movies. It’s your fun money. Of your entire budget, only your Discretionary Expenses can’t be automated, and even then, you can purposefully decide to fund a budgetary category—or even a separate bank account—for fun money to ensure that you’ll always have cash for spontaneity, a meaningful Enough boost.

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How to Make Budgeting (Almost) Enjoyable

How might we view budgeting and cash flow differently, not as a tedious task that we have to do, but a life-giving task that we get to do? Not as a system of carrots and sticks that provoke rebellion, but a source of motivation? Not as a compulsion, but an impulsion? Let’s recall Daniel Pink’s successful motivational criteria from chapter 3. Then, budgeting would be

1. Self-selected: your initiative, not someone else’s.

2. Authentic: consistent with your personal gifting and attributes.

3. Others-oriented: a cause that is bigger than you.

Budgeting can feel like a “should,” but it doesn’t have to. Do it on your terms. Here’s what my self-selected routine looks like:

After breakfast on Saturday morning, I top off my coffee, collect my wallet and the week’s receipts from my wife, and head into my home office and close the door. I put on an album (collections of songs by a single artist, popular in the previous millennium) that I’m really enjoying and begin entering the week’s purchases.

Yes, you heard me correctly. I actually review every receipt from every transaction in a given week and manually enter them into my budgeting software (more on that in a moment). Then I reconcile each transaction, toggling back and forth between the budgeting software and my bank’s online list of transactions, just to make sure nothing slips between the cracks.

This is undeniable tedium, but for me, the weekly budget routine has almost become cathartic. Here’s why:

It’s easy. In fact, it’s easy enough that I almost consider the budget element of this exercise to be ancillary. I’m enjoying a cup of coffee in solitude while soaking in some good music. Oh, I’m also doing the budget. Then, once I’ve completed the process, it’s a big weight off my shoulders. I enjoy the rest of my weekend more, knowing where we stand financially.

Simple Money Journal Entry

Life-Giving Budgeting

I’m not suggesting you adopt my cash flow review routine, although you’re welcome to. Instead, what would a life-giving budgeting exercise look like for you?

The Freedom of Discipline

Does the word discipline have a positive or negative connotation for you? I think for most of us, our foremost gut reaction is negative. It feels restrictive. It feels like an imposition, stealing our freedom. But, when rightly applied, discipline actually breeds freedom.

How? Well, consider a single line-item in our household budget: “Date Night.” There are many joys that come from being a parent with young kids, but the demands of such a household have a tendency to relegate Mom and Dad’s relationship to being more about business than romance. That’s what date night is for, to remind us what got this whole family thing started.

It’s hard enough to muster the requisite creative energy to plan a date night, from lining up a babysitter to making dinner reservations and checking movie times. And that doesn’t even take into consideration what goes into planning those special occasions. Then you have to worry about whether or not you have the money, ’cause a great date night ain’t cheap if you do it right.

For many years, we didn’t have a specific category within our budget to fund this marriage-strengthening exercise. So it always felt like we were stealing from another category to raise the cash necessary to fund our night on the town. This was no doubt the last straw, and it led to the abandonment of many date night plans. But now it’s funded. Money is set aside each month to ensure we don’t have to hurt ourselves financially to help our marriage.

The “restriction” of tracking our cash flow surprisingly breeds the opportunity for spontaneity where it might otherwise have been impossible. Or, as Richard Foster, author of Celebration of Discipline, puts it, “Discipline brings freedom.”

Sounds great, right? So, how do you get started if you don’t have a budget?

Cash Flow Tools

There are many online tools and apps available to help make budgeting as easy and effective as possible. Most of them are variations on the theme of envelope budgeting. With the original envelope system, you cash your paycheck and put predetermined amounts of cash in envelopes marked with the budget category. Then, when you get to the bottom of the cash in each category, you’re done.

The envelope system certainly works, and its tangible nature helps get more of our senses involved. It is, however, cumbersome and less than secure with all that cash floating around. It should be used primarily as a short-term boot camp for jump-starting a budgeting initiative. You may consider going straight to an online- or software-based system instead.

I believe the easiest system to use is Mint.com, which I mentioned previously. Their system will actually aid you in more deeply understanding the process of establishing and maintaining your budget. Furthermore, if you’re willing to plug your online bank usernames and passwords into the system, it will practically do your budgeting for you. It automatically categorizes each transaction and lets you know when your budget limit is approaching.

Newer entrants to the high-tech money management space, like Levelmoney and Personal Capital, are compelling and surprisingly easy to use. But can budgeting be too easy?

I asked Jesse Mecham, the founder of YNAB cash flow software, why he hasn’t added the Mint-like features of auto-categorization to his well-respected program. He told me that, while convenient, the auto-categorization makes the process too easy. “I didn’t know there was such a thing,” I said. But his response made a lot of sense.

If the program is too automated, Jesse told me, then budgeters aren’t cognizant enough of their spending and the impact of individual transactions. I buy that. Cash flow management is most effective as an exercise in deliberate self-awareness.

YNAB involves a bit steeper learning curve than Mint, and it does have a price tag.1 But it offers sufficient instructions and online classes to make it worth every penny.

Of course, it’s important to remember that cash flow management is just a means to an end, a tool to be used in navigating the three guarantees in financial planning—surprises, change, and failure.

Three Guarantees in Financial Planning

We err if we believe adequate preparation will help us avoid surprises in life. Preparation simply lessens the potentially negative impact of those surprises. The antidote for surprises is margin.

Margin is the buffer between what we think will happen and what actually does. Humans are notorious for underestimating life’s hurdles and overestimating our abilities to overcome them. This is why it takes 50 percent longer to finish your paper, why it costs 25 percent more to complete your home renovation, and why I should leave 10 minutes earlier every time I’m driving somewhere.

There are a few ways we can employ margin to better navigate life’s financial surprises. The first is to maintain sufficient emergency reserves, discussed at length in the previous chapter. The second is to set each of our budget categories just a shade above our average spending, like setting your watch five minutes fast. And finally, fund a separate budget line item that reads “Margin” or “Buffer,” just to soak up any monthly overspending.

Margin serves us well both in money and life. Overcommitment is the scourge of our generation; busyness is the tarnished badge of honor we wear to validate our self-worth. But it’s not Enough.

The second guarantee is change. It’s been said that death and taxes are life’s only two guarantees, but taxes appear optional in several European countries and I’m still hoping to go out like the prophet Elijah, on a chariot of fire. Change, however, is inescapable and shouldn’t come as a surprise. The counteragent to this guarantee is flexibility.

From a cash flow perspective, flexibility is especially valuable when we change jobs or homes. You might move to an area with higher taxes and be forced to endure a reduction in your net pay, which affects all your budget categories. Even a change as apparently innocuous as your employer making the switch from paying you twice a month to biweekly can have a meaningful impact on your budget. And that’s not even to mention a job change with a totally new compensation regime. A planned pregnancy is no surprise, but it will impact your budget materially the next couple of decades (at least).

It helps to hold very little sacred in your cash flow planning, as any number of life’s changes—welcome or unwelcome—can force you to bend your expectations and planning. And remember, that which is unwilling to bend often breaks.

The last guarantee in financial planning sounds a bit defeatist. However, failure need not be viewed as terminal. Have you heard the term “going to failure” in the context of fitness and exercise? The idea is that our muscles grow when we allow them to be expended to the point of exhaustion. We must push beyond our limitations to grow, even though we know that the immediate result will be failure.

That we have an opportunity to grow through failure doesn’t mean it’s painless. It hurts, but the pain is salved by grace, something we must often extend to ourselves and anyone we’re partnered with financially. Grace is unearned favor—it’s a slate cleaning. It’s erasing the record of wrongs, allowing us to move forward with dignity and the confidence that we can do better.

In the words of philosopher (and Pearl Jam frontman) Eddie Vedder, “[It] makes much more sense to live in the present tense.”

Matrimony and Money

With more than 50 percent of marriages ending in divorce and more than 50 percent of those splits attributed to financial disagreements, it’s safe to say that money is the most dangerous element within the context of matrimony. My wife and I are no different. Our cash flow personalities are markedly different, attributes we can clearly trace to how we were raised.

My father was the first of his lineal descendants to go to college, an endeavor he took on without any financial aid from his family. They simply couldn’t afford it. His father, a World War II vet, was stably employed but in a trade that didn’t allow for any extravagance at home.

Dad got a degree in engineering, only compounding the effect of his frugal upbringing. (Know any engineers? You understand what I’m talking about.) It became part of his parental duty to ensure that my brothers and I were not prone to indulgence. Even though we were far better off financially than he in his upbringing, my father believed that familiarity with deprivation was a useful tool in developing financial discipline. So, you can guess what his response was when I pleaded to get the sleek Adidas Samba soccer shoes because “All the cool kids have them!” You guessed it—Keds.

My wife’s father was born into abject poverty, in a German work camp at the tail end of World War II after his parents’ homeland, the Ukraine, had been taken over. His family was blessed to immigrate to Canada, but beginning from scratch without any marketable skills, life in Calgary was bare bones.

After putting himself through undergraduate and medical school, which eventually afforded him a much more comfortable living than the one he’d known as a child, my father-in-law made it his mission to ensure his children would not feel the sense of desperation he knew so well.

Even though both of our fathers grew up relatively poor, they each employed what they learned honorably—but very differently—as parents. How do you think all this disparate background played out in the early years of our marriage?

On paper, Andrea and I don’t represent polar extremes. She’s not a consummate Spender and I’m not a dedicated Saver (chap. 7). But it sure as heck feels like we’re opposites sometimes. We’re not the only couple to amplify each other’s less-than-admirable financial characteristics, are we? The statistics would suggest not.

So, how do we keep our financial dissonance from becoming a fatal flaw in our marriage? First, we try to see each other not as a stingy scrooge and a wasteful spendthrift but as a collection of our life experiences. As Rick Kahler, the Money Script guy, says, “All financial behaviors, no matter how illogical, make perfect sense when we understand the underlying beliefs about money.”2 These are informed by our life experiences, especially those of our youth (chap. 2).

Next, we stop demonizing each other and try to see ourselves as closer to one another on the continuum. And best of all, we try to recognize the strengths of the other as complements to our weaknesses, not as threats.

This is, of course, easier said than done—especially in the heat of disagreement—but it could just save your marriage.

Simple Money Journal Entry

If you’re married, how well do you understand your spouse’s—and your own—financial past and the impact it has on the present?

Congratulations!

You’ve done the challenging but rewarding work of the five foundational chapters. You also know where you are on the map financially and you’ve taken stock of your cash flow personality strengths and weakness on your way to accepting your new role as an effective CFO for your household.

Now it’s time to start planning for your future, beginning with a look at the simple investment portfolio that has beaten the pros.

Simple Money Financial Statements Summary

1. You are your household’s default CFO—how are you doing?

2. The most important indicator of a successful financial plan is the household cash flow mechanism.

3. There are three personal financial statements we use to navigate our financial realm:

· The Balance Sheet takes a picture of your present financial situation.

· The Cash Flow Statement examines our categorical past spending.

· The Budget forecasts a spending plan for our near future.

4. Cash flow management, even with the best tools available, isn’t going to be fun, but we can design a rhythm that is self-selected, authentic, and others-oriented to help motivate ourselves to action.

5. The three guarantees in personal finance are surprises, change, and failure, but they can be countered with margin, flexibility, and grace.