By: Tim Bennett
01.05.2019
01.05.2019
“When can I afford to retire?” is one of many questions that can be answered with a good financial model. Tim Bennett explains how in his latest video.
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How a cash flow model could change your life
Big financial decisions around school fees, retirement or even just funding a sabbatical can be tough to make. However, they get a lot easier with the right financial model. Here is a short overview.
Background
Most of us are not very good at forecasting in our heads. The reason is there are too many variables (growth rates, inflation, the timing of cash flows) to get right even when it comes to fairly simple decisions like the timing of a house purchase. As a result, we often bury our heads in the sand when, with a bit of effort, we could make our financial lives a lot clearer and less stressful by being a bit more organised. Enter cash flow models.
What is a cash flow forecast?
These can be simple or quite complex, according to your objectives. They start with a clear picture of your assets and liabilities and the build out your expected income and expenditure into the future with the aim of clarifying key decisions. They are, by definition, therefore based on estimates, as no-one knows for sure what the future will look like.
Key decision points that a model can help with include when someone can afford to buy a property, clear a mortgage, retire or just work fewer hours.
They way they look can vary depending on who builds them. Here is an example.
The various coloured lines are trying to show whether and when a hypothetical individual may run out of money under different future growth assumptions. Nothing here is guaranteed here, but at least this sort of chart gives a clear picture around how the future may look. Planning for it then becomes a lot easier.
The key ingredients
Even a simple model requires certain key bits of information and some important assumptions to be made.
Garbage in, garbage out
Getting the level of detail right is tricky. A good model will contain enough to be useful but not so much that it becomes overwhelming, or unwieldy. Either way, it must be complete – a common error is missing out a key piece of debt, such as a personal loan, at the start. This will skew the whole subsequent picture.
Assumptions
In order to project forward, you will need to make a number of key assumptions and be prepared to update them as things change over time. Here are three;
Growth rates in particular are tough to forecast so a good approach is to test a model under different ones to see what the range of likely outcomes may look like.
Regular reviews
A cash flow model is designed to be a dynamic document. As such, you should review and update it every year as a minimum and more often if your circumstances change. The more you use it, the more useful it will get.
To find out more
The Spring 2019 issue of Confidant contains an interview with our Head of Planning, Svenja Keller, where she explains her approach to cash flow modelling and answers some common questions. Please email me if you would like a copy.
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