Free Cash Flow and Your Debt

by Kevin on April 24, 2009

Free cash flow is technically a corporate finance term that represents the money that is left after spending money to maintain the company’s current asset base. (You can read up on the corporate version at Investopedia.)

For personal finance it is slightly different; in fact it is much more similar to the corporate finance term net income.

Essentially what I call free cash flow for personal finance is:

= Total monthly income minus total month expenditures (rent, utilities, gas, minimum debt payments, etc.)

It’s what’s left at the end of the month after you’ve paid all of your bills and spent all the money you are going to spend for the month. Naturally we need this number to be positive — this indicates you earned more money during the month than what you spent. You should have money left in your bank account. If you don’t have any money left and you’ve spent more than you’ve earned during the month, you have negative free cash flow. That’s bad — you’re getting deeper into debt.

Free Cash Flow Can Defeat Your Debt

The beautiful thing about free cash flow is it can allow you to defeat your debt. Let’s say you have $200 left at the end of every month for an entire year. You’ve also got $1,000 in credit card debt. Do the simple math and apply that $200 to your credit card debt — you’ll be out of debt (assuming you stop adding charges to the credit card!) in just 5 months.

Of course this requires you to maintain a fairly strict budget. Having unexpected expenses (or wasteful spending) dig into your free cash flow every month will kill your ability to apply the money to debt.

Negative Free Cash Flow Can Defeat You

In fact it is almost a certainty. Consistently spending more than you earn — aka getting deeper and deeper into debt — is not sustainable. Eventually you will hit a wall where you can’t even make your minimum payments. Once that happens, you’re done.

Consider the same situation I mentioned above, but reversed. You’ve got a $200 hole in your budget. Each month you spend $200 more than you earn.

It’s completely unsustainable. You’re digging, and digging, and digging into debt. The next thing you know you can’t even see the top of the hole where you started digging.

Keep a Budget to Monitor Free Cash Flow

You need to know two things about free cash flow.

  1. How much money you should have at the end of the month, based on a budget
  2. How much money you do have at the end of the month, based on your spending

If your budget shows you should have $200 left over, but in reality you have $25… that’s a problem. You’ve got a $175 leak in your budget. Investigate and shut off the leak.

Budgeting is so critical and really doesn’t require too much work. You can do a budget on a piece of paper with a pen. You don’t have to use Excel or an expensive online tool. Pen and paper and a little bit of time. Your budget is chock full of information currently hidden from view — like how much free cash flow you should have at the end of the month.

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Corporate Barbarian April 24, 2009 at 12:44 pm

In my company, we call it Net Cash, the difference between your cash collections minus your expenses. I keep a weekly budget in Excel that allows me to project the net cash that I can throw at debts.

Kevin April 27, 2009 at 8:56 am

@CB: Yea I’ve seen net cash and net income. Income being this is all of the money you’ve got left after paying out all of your expenses.

Either way it is good to track. We live off of last month’s income so at the end of the month after I update the budget I can see how much cash we have left versus what we should have had.

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