Cash Flow and Cash Coverage
In A Family Setting
We’re going to circle back and cover reader feedback on the personal planning posts. As a reminder, he’s the link to the Family Financial Review Template.
My wife enjoyed the post but said the detailed discussion lost her.
Impact of Borrowed Money
When running through the template with people… I see the most glazed eyes with the Scale Your Financial Wealth section…
Gross1 Assets ➗ Core Cost of Living = years
***Net assets ➗ Core Cost of Living = years***
***Cash ➗ Core Cost of Living = years***
The ***BOLD*** lines are where we can get our families into trouble. I’ll share a couple snapshots of my own life to illustrate.
In my early 30s, I was living in a 5-bedroom house in Christchurch, New Zealand…
Gross Assets = $1 million
Core Cost of Living (CCL) = $50,000
If we divide the Assets by the Core Cost of Living (CCL) we get “20 years.” Only 15% of the assets were tied up in my house, leaving me a lot of flexibility.
My balance sheet was not enough to retire, but it gave me comfort that “one more year” of part time consulting and full time triathlon was low risk.
From the original article:
Gross vs Net makes it obvious if you are over leveraged.
Let’s take the same starting figures and change the capital structure. Assume, back then, I had a mortgage to go along with the earlier numbers.
Gross Assets = $1 million
Total Borrowings = $500,000
Net Assets = $500,000
Core Cost of Living (CCL) = $50,000 + $44,000 = $94,415
The impact of borrowing:
Core Cost of Living (CCL) has increased due to the mortgage (back then rates were ~8%).
The debt is $500,000 and the net assets are $500,000 (gross assets “minus” debt “equals” equity/net assets).
Now, instead of having “20 years” of Core Cost of Living (CCL), I would have had 5.3 years. This is calculated as: Net Assets / Core Cost of Living (CCL) = 500,000 / 94,415 = 5.3 years equivalent.
Cash Flow & Risk Profile
But there’s more going on. The risk profile is changed by borrowing.
While my Core Cost of Living (excluding debt) has stayed the same, my ability to shrink my spending is severely constrained by having the mortgage.
Back then, my “Plan B” was:
Rent out three rooms of my house. ($7,500 of additional income)
Cut out international travel. ($25,000 reduction in spending)
Without a mortgage, that would have shifted my CCL from $50,000 down to $17,500 (-65%). With a mortgage, the CCL shift would have been $94,415 to $61,915 (-35%).
At the time, my coaching business generated ~$35,000 per annum.
Being debt financed is the difference from my coaching business covering 200% of my worst-case cash flow needs and 50% being covered.
Put another way… using debt to size up my life would have been the difference from being able to quickly move to a cash flow surplus or be caught in a deficit. When we are starting out (with student debts and/or no assets) we can’t avoid the risk of running a deficit. However, we don’t need to continually place ourselves in this position.
++
I arrived in New Zealand debt free and without home ownership. At the time, I knew my different income streams:
Cash Flow from Coaching Business.
Cash Flow from Financial Consulting.
Deferred Compensation.
Cash Flow from Investments.
1 & 2 are active income. I needed to deliver services to earn them. 3 & 4 were passive income. Passive income arrives with no effort on our part. Being able to cover our CCL with passive income puts us in a secure position. For most of us, it takes decades to get to this point.
As a new arrival in New Zealand, I didn’t have any credit history so I’m not sure I could have borrowed (even if I wanted to). However, I didn’t want to borrow because I saw one income stream could cover my worst-case scenario. The additional risk, from sizing up with debt, wasn’t worth it.
Four years later, still owning the house in New Zealand, I had the opportunity to purchase a property in Boulder. Once again, I “bought less” and didn’t borrow. In Boulder, I bought a three-bedroom townhouse. Again, I had the option to generate rental income, if supplemental income was required.
Time Horizon, Risk & Cash Coverage
Typically, we’re not living in a worst-case scenario. Good times prevailed from 2000 to 2005. My coaching business grew. Financial consulting projects were easy to find and lucrative.
I was married (2005) and realized I had increased my cost of living to the point where I’d have to “go back to work” if anything happened to my main client (a start-up I’d helped get going). I was still “debt free” but I’d co-signed a letter of guaranty for a line of credit in the start-up.
A rule of thumb in the risk management business…
Given enough time, anything that can happen will happen.
I wasn’t willing to live with the consequences of something going wrong with my employer. I loved being able to control my schedule.
Why was I so uneasy?
Well, not only did I have a letter of guaranty outstanding, I had a line of credit in place on my house down in Christchurch. I did this because of a ratio I shared above…
Cash ➗ Core Cost of Living = years
At the time I got married, the ratio above was “1 year.” This ratio is called a Cash Coverage Ratio. It is the answer to the question… How long can you last if your income & revenue went to zero, today? You always want to know the answer to this question.
The line of credit on my house could have provided another year of cash flow, if I needed it.
Two years is a lot of time to get organized but… I didn’t want to get organized… I wanted to maintain freedom to do whatever I wanted.
My wife had spent two Southern Summers in Christchurch and knew what that part of my life was like (often cold, wet and windy). The start-up was about to be profitable and we decided to restructure our lives.
Sell the NZ House.
Ditch the line of credit.
Sell a share of the start-up.
Ditch the letter of guarantee.
Shift my financial consulting business to Bermuda (a story in itself, we also looked at Cayman Islands).
Consolidate into a debt-free Boulder house (we looked at buying in Bermuda).
The house was 6,000 sq ft.
A pleasant (but expensive) error that would take ~10 years to unwind.
The lesson being… don’t size up into non-yielding real estate before a banking crisis.
The error was not maintaining what I had constructed when I moved to New Zealand, the ability to easily cover my cost of living with simple changes in lifestyle. When the Great Recession of 2008/2009 hit, my error proved painful but not fatal. The financial lives of several friends were not so lucky.
There were bankruptcies and insolvencies in my peer group. One of which was my employer. I had the experience of effectively firing myself (and creating a massive contingent liability) on my 40th birthday. This happened when I put the group (that indirectly paid my salary) into receivership.
Overnight, my income went to zero.
At the start of the following year, my Cash Coverage Ratio was 4 years. One year later, it was up to 10 years. I was debt free, healthy and had time/capital to restructure my life.
Lessons For Your Family
The purpose of the first example was to show the impact of borrowing on your family’s flexibility and risk.
Across decades, setbacks are likely.
Surprise unemployment is an example. Income reductions are common over our careers.
I’ve also had large expenses “fall out of the sky” and land on my family. Up to the equivalent of a year’s family spending.
The largest drawdown I’ve experienced on my net worth was 65%. Massive and painful. However, because I apply the lessons you read on this site, it had zero impact on my long-term quality of life.
These setbacks, surprise expenses and drawdowns are common. Talk to elders with experience in finance. Setbacks suck but don’t need to be fatal for your family finances. You can work through them.
Fewer Assets & Less Borrowing = Greater Flexibility & Lower Risk of Ruin
The time to borrow heavily and “size up” is when we are using other people’s money. There are times, and deal structures, where it’s nearly impossible to lose. These opportunities rarely apply to family money.
The exception is when your family has the ability to be a cash buyer during a banking crisis. Of course, we need the courage to make an investment when the financial world is burning down. Most people can’t pull the trigger.2
++
Next up, I gave you an example of income streams, both passive and active.
Many families have multiple income streams due to dual income earners, working in different industries.3
The “game” here is seeing different ways the family can meet its Core Cost of Living. Sit down and map out your Plan B, and C and D. When I was single (and spending most my time as an elite athlete), I had four different ways to cover my expenses.
In finance, frequently, there is a single earner making a huge salary. Alongside the salary is a high burn rate, school fees, borrowings and non-yielding assets. So long as nothing happens to the earner, or their job/company, the family is set. But things do happen. Knowing Plans B through D gives comfort.
++
We ended with a story about the Cash Coverage Ratio. A simple way to see how long “the lights can stay on” during unemployment. In my example, I was using a mixture of cash, and credit lines, to ensure I had time to make adjustments.
In times of financial stress:
Credit lines can be pulled.
Cash can be unavailable.
Loans can be called.
Assets can be unavailable to sell.
I’ve lived through all of the above and I’m not _that_ old.
Cash being unavailable is usually short term in nature. To ensure access to cash, consider bank accounts that are subject to different monetary authorities (Europe/Asia/USA/Canada, for example).
Have cash sitting at banking institutions that are separate from any borrowings. I’ve seen banks seek to “net” debts with cash on hand.
Hope this helps.
Monica read an early draft and asked “gross or net… of what? Taxes?” Not taxes in this case.
Gross means “before” and net means “after.” It’s always worth being clear about before/after what.
In the first formula, “Gross Assets” is all the assets held by the family. “Net Assets” is all the assets after deducting liabilities. The big liabilities for most families are debt/borrowings and deferred taxes (the taxes that would be payable if all assets were sold at market prices). If your family owns a lot of real estate then deferred agent’s fees can also be a large number.
Don’t believe me? What did you buy on March 22nd and 23rd 2020? Those two days covered a year’s worth of living expenses for my family. I trade on less than 1 day in 100. The rest of the time, I live my life.
Related to income streams and risk… don’t invest your pension in your employer’s stock. Not worth the risk, you’re already exposed via employment. Ask any long service United pilot what can go wrong.
So many overlaps with my own story G. Thank you for sharing this experiences, they resonate and amplify in what is important 🤙🏼
Your writing has helped me to shape how I'm teaching my adult children on this topic, which coincidentially is not too different to lessons passed to me by my Grandfather!