Using cashflow modelling to help plan your financial future
No one can accurately predict the future.
To be honest, even if crystal balls did exist, at the start of 2020 even the most efficient model would surely not have predicted a worldwide pandemic resulting in a year-long lockdown.
What we can do is use the data and information available to us to make informed and educated assessments of what we think might happen, and then use that information to help us make key decisions.
From a financial planning perspective, one of the ways I do this with my clients is by using cashflow modelling.
In simple terms, cashflow modelling is the process of assessing your current wealth and, from this, forecasting how it will change in the future.
It considers both income and expenditure, helping to make clear how your finances could alter in future years. Clearly there is a lot that feeds into the process and the more information that’s used, the better the results.
So, I try to use information covering a whole list of subjects. These include property wealth, investment values, fixed income, and debts. I’ll also include the value of your business – property and assets.
I’ll also take into account future known events that will impact on your wealth, both positively and negatively.
Once all that information is input, I can then calculate how your wealth will be impacted by factors like inflation, interest rates and investment performance.
Here are six ways using an effective cashflow modelling tool can help you plan your financial future.
1. Projecting your lifetime wealth
The key output produced by a cashflow modelling tool is a projection of your future wealth, based on the information I have input. This will act as the starting point, from which we can then model future scenarios and the impact of external events.
This will model the probability of you running out of money at some time in the future.
By knowing that there is as low probability of this means that you’ll be in the enviable position of going to work because you want to, rather than because you have to.
2. Analysing how you spend your money
As well as projecting future wealth, a good cashflow modelling tool will also help you keep track of where your money is going. So, if you are looking to increase the amount you contribute to your pension, for example, it will help you identify where potential savings can be made. It will also illustrate the impact those increased contributions could have on your future wealth.
3. Demonstrating the effects of varying inflation and investment returns
Cashflow modelling allows you to “war game” various financial scenarios and see the impact these could have on your future finances.
These can range from the simple impact of different rates of inflation and investment return to more complicated scenarios like a severe investment downturn – such as the one we all experienced last year. This can be particularly useful to help ascertain the robustness of your investment portfolio and help us weigh up risk with potential returns.
4. Helping you see all your options
Although I don’t run cashflow forecasting for your business, I do understand how consumed you are by your business, and how it can come to dominate your life.
In this instance, therefore, what I can use cashflow forecasting for is to help you understand how much you need to do all the things you want to do.
Once we’ve established that, and you’re comfortable with the details we’ve arrived at, we can then begin a separate, informed discussion, around how much you need to sell your business for in order to be able to live the lifestyle you want.
Several business owners I have talked to during the pandemic have realised that they have been over-relying on the current sale of their business to provide the capital for their semi, or full retirement.
It therefore makes sense to gain some control and become financially independent of your business rather than dependent on it. This can be achieved by investing outside of your business. Don’t get caught out!
5. Seeing how life events could have an impact on your finances
As we have already said, you can’t always predict what will happen, but cashflow modelling can help you plan for the potential upheaval of big events.
It can also give you an idea of how long you can take a lesser amount out of your business – maybe forsaking dividends, without sacrificing your current lifestyle.
6. Planning your legacy
By giving you a clear idea of how much your assets will be worth when you die, cashflow modelling can help with your legacy planning.
It is much easier to manage issues like Inheritance Tax planning, and ensuring your family get more of your wealth than HMRC when you die, if you have a better idea of the potential value of your estate.
The importance of keeping cashflow modelling data up to date
It’s crucial that the data we’re using is kept up to date, and that we review it regularly. I like to run cashflow modelling with my clients at least annually.
Annual reviews mean that the data and information we’re using is as up to date as possible. This means that the results and projections are equally up to date and relevant to your specific financial position.
I also recommend that we use the modelling tool after any big financial events.
Using the right modelling tool
Having established how important cashflow modelling can be when it comes to helping plan your financial future, one key issue is which tool to use. As you can imagine, there are a range to choose from.
Many rely on “straight line” investment projections – assuming an annual investment growth of X%. This approach raises two potential issues:
- It can create an over-reliance on the “X” figure, resulting in possible overreaction if that figure is not achieved in a particular year.
- It does not reflect real life, where markets go up and down rather go on a linear journey.
That’s why I’d rather use a modelling tool that allows a far greater degree of flexibility with my clients.
The tool I use tests extensive historical data from over a thousand actual scenarios to determine their impact on the asset classes in the client’s portfolio. It’s very much based on real world returns, rather than simple uniform projections.
This means that it can stress-test a particular investment portfolio based on previous events. For example:
- What would happen if there was a repeat of the early 70s bear market when UK equity declined by 67%?
- How would another “Great Crash” like 2007/08 impact my investments?
With a more sophisticated tool, we can answer both questions. Clearly these are both extreme events, but by incorporating these into our long-term investment planning, we can ensure your investment decisions give you the best possible outcome. We can stress-test how your investments and retirement planning would cope in extreme circumstances.
Get in touch
As I said at the very start of this article, you can’t predict the future. But by using the right cashflow modelling tool, and by making sure the details we are using are as thorough as possible, we can add real value to your financial planning.
If you would like to know more about how I use cashflow modelling, and how it could help, please get in touch. Complete the contact form or please call me on 020 3813 8265.