The basics of cashflow modelling

Financial planning is basically the art and science of balancing your needs (and wants) in the present with your needs and wants in the future.  Of course, the future can mean anything from the next few seconds to the time until your death (and maybe even beyond if you have dependents and/or are concerned about leaving a legacy).  A lot can happen in that time.  Some of it may be utterly predictable, some of it may be utterly unpredictable, some of it may be considered as a possibility if you stop and think about it.  That’s where cashflow modelling can help.

Budgeting versus cashflow modelling

Budgeting is basically the skill of making your money last your month.  It’s easiest when both your income and your expenses are regular and predictable and, by contrast, it’s hardest when you have both variable income and variable expenses.  Cashflow modelling is essentially using historic and current information, together with assumptions about what the future might hold to inform your decisions about what you should do with your money in the present.

A very basic example of cashflow modelling in action

Two people have a baby.  They predict that it will grow up into a young adult, at which point it will appreciate any help they can give it with the transition into adulthood.  They, therefore, decide to open a Junior ISA and plan to contribute the maximum each year.  They also plan to open a Cash ISA when their child turns 16 and contribute the maximum to that too.

When you look closely at this (imaginary) case study, you can see that it is a mixture of facts and assumptions, both about the child’s future and about the financial landscape.  The fact is that the child has been born.  The assumption about the child’s future is, essentially, that it will have one.  In other words, that it will reach young adulthood (and beyond).  The assumptions about the financial landscape are that both Junior ISAs and Cash ISAs will continue to exist, that Cash ISAs will continue to be available to people at age 16 and that both will continue to offer a good deal.

More advanced cashflow modelling

Now let’s fast forward 18 years and wave the child off to university.  You are confident that, thanks to your earlier saving, your child can now be considered financially independent.  It’s, therefore, time to focus your attention on your own plans for the future, particularly retirement.  You are, however, aware that, even though your child should be able to keep themselves from now on, they may struggle to put together a deposit to get on the housing ladder and you’d like to help them with this – as long as you can do so without compromising your own plans for retirement.

At this point, you have a much greater range of facts at your disposal and also a much greater range of assumptions and possibilities to consider.  For example, you will know the age at which you can retire (even if you do not wish to do so) and, if you own your own home, you will know the remaining mortgage term and amount owed.  You will, however, need to make assumptions about interest rates, inflation rates and the returns on savings and investments.

Because these last three points are essentially guesses, you might want to think about a range of scenarios such as best case, worst case and likeliest case and see what each of them means for your future (and your child’s future).

Although you most certainly can undertake cashflow modelling (even advanced cashflow modelling) on your own, it can be very helpful to have your calculations double-checked by a financial professional.  They may be able to offer advice and suggestions which would not have occurred to you on your own.

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