Just as the flow of water supports life, the starting point for managing your finances is to develop mastery over the flow of money: to enable inflows and minimise outflows with the end goal of accumulating wealth.
The cashflow equation
Knowing how much of your income is left after expenses is critical because these are the funds that could be used to build wealth. You can use a simple equation – the cashflow equation – to work this out:
Assessing your cashflow health
To assess the health of your cashflow a number of key measurements are useful:
The Savings Rate which shows how much of your disposable income (income after tax) is saved. The higher the rate, the better, but your savings rate can fluctuate as your circumstances change.
The Debt Service Ratio shows the portion of your disposable income used to make debt repayments. The lower your debt service ratio, the better. Lenders in some countries use this ratio to assess your ability to pay back debt.
If your income stops all of a sudden (e.g. you lost your job), how long can you get by before you will need help? The Quick Ratio shows how long you can meet your regular monthly expenses using your cash or liquid funds. It is calculated by dividing the amount of liquid assets you have by the regular monthly expenses. The regular monthly expenses include living expenses and regular loan repayments. Liquid assets, for the purposes of this calculation, are cash or assets that could be converted into cash in less than 2 weeks.
