STEP 3: MAINTAINING PROPER CASH RESERVES
Cash is king, and the benefits of significant and liquid cash reserves will change your economic future more than you can imagine.
The expression “cash is king” has been around a very long time. It appeared in news and publications prominently in the ’80s and has come to be a favorite phrase used by thousands of financial gurus, advisors, lawyers, and accountants over the years.
I think my dad may have even taught me the concept (he was a successful entrepreneur in the medical industry for years). But it truly didn’t take hold in my personal investment life and have deep meaning until I had already been a lawyer, an accountant and a business owner for years. Sometimes, we don’t really understand the importance of cash and expenses until we own our own business.
As I mentioned in Chapter 5 regarding the 4 × 4 Independence Plan, I was reminded of the practical importance of this by Dave Ramsey. I love the revolutionary steps and concepts that he teaches in his Financial Peace University. I was blown away with the simplicity and genius of his first step: that of saving $1,000 in a separate bank account for emergencies.
Of course, there are many reasons for this strategy and why it’s the first step in his program, but most importantly, it sets the foundation for having a financial cushion in your life. Dave Ramsey has explained it so many times in his teachings as a buffer between you and life’s happenings. But frankly, it’s just the beginning for an entrepreneur.
This is where Dave Ramsey helps millions of people around the country, but again he stops short when it comes to expanding this strategy for the entrepreneur. This is where Randy Luebke made a huge impact in my life and took the concept of reserves to the next level. During his many years in the financial industry, Randy learned two very important lessons about cash and passed them along to me:
Having enough cash to help you weather the storm during the bad times, when things go wrong.
When opportunities present themselves (and they will), if we don’t have sufficient cash reserves to exploit these situations, huge returns can pass us by. In other words, when things go right or when things go wrong, having available cash will allow you the best opportunity for a successful outcome.
Cash Reserves Means CASH Reserves
It’s important to mention right from the outset that both Randy and I strongly believe that credit cards and Home Equity Lines of Credit (HELOC’s) are NOT cash reserves!
Yes, I know the counterarguments all too well. We have very dramatic conversations with clients that fight back on the idea of setting up a cash reserve fund. They say that they don’t want it or need it. They do not want cash in their checking or savings account earning no interest. Instead, they always want it invested. Their comeback is most often, “If I really have a need for cash, I have $50,000 of unused credit cards or $100,000 of an untapped Home Equity Line of Credit (HELOC) to get me by.” We agree that using debt may work in some business situations, but once you bring your personal assets into play, you run much higher risks. Remember that with debt comes the obligation to repay, and that’s what can make things go from very bad to really ugly over a short period of time. The idea of cash reserves is to have actual, available cash!
RANDY LUEBKE
They say that “money can’t buy you happiness,” and I agree. However, having money/cash in a very safe place that you can go to when needed can buy you a lot of peace of mind.
Additionally, many people rely on their credit when times are good, only to find it unavailable when things turn bad. Credit cards as well as HELOC’s can be frozen or the amount of credit available can be reduced by the lender at their discretion and often at the worst possible time. Moreover, one of our primary strategies is to stay out of consumer debt. That is why we stress having actual cash reserves.
I often see people with far too little, and limited, cash reserves. They may have enough money set aside to get them through a month—possibly two or three. But that’s not really enough, and as an entrepreneur you definitely need more.
Randy’s personal advice to me was astonishing when I thought I already owned this concept and was fine. Furthermore, I was a follower of Dave Ramsey’s teachings, so what more could Randy teach me about reserves that I didn’t already know? Randy’s direction to me, and to all of his clients is that we need to have significant liquid cash reserves on hand. Significant reserves mean that you have a substantial amount of money in reserve, not just a few bucks to get you by. Of course, this is a subjective amount because everyone’s lifestyle and needs are different.
How much you need in your personal situation will depend on a number of factors, for example, the reliability of your income, the amount of risk you maintain, your monthly business overhead, your personal living expenses, the needs of your family, your tangible assets, and even your age, just to name a few. You want to be able to stay afloat and have cash flow when times are tough due to loss of a job, an economic downturn, etc. You also want to be able to utilize the cash when you want to put a down payment on a house that you want to buy before someone else beats you to it. Remember, cash reserves are not only for emergencies; they are equally important for potential opportunities.
Liquidity is the engine behind the reserve, and if you have significant reserves, but they aren’t quickly accessible, what’s the point? In fact, you have missed the point altogether, and you’ll be back in the debt cycle relying on lenders to help you get out. Liquidity means being able to get to your money when you need it. That’s why some people call their cash reserve an emergency fund, while others call it an opportunity fund. It is readily available if there is an emergency or an opportunity.
The Three-Bucket Cash-Reserve System
In order to have both liquidity and significant cash reserves, it takes more than just plowing cash into a bank account. It’s a unique structure called the “Three-Bucket Cash Reserve System.” This system not only ensures that you will have enough readily available cash that is safe and secure, but it will also allow you to earn a fairly decent overall rate of return on your money as well.
What I also like about the Three-Bucket System is that I could do it in stages. Once I got started, the reserves became such a comfort and strength that I truly wanted more. If I dipped into my reserves at all, for anything, good or bad, I was extremely anxious to get the money back into the system. I was addicted to the security and flexibility it offered me. We start with the first bucket to build some confidence, momentum, and yes, better habits, and then we can graduate to the other buckets. It’s easier than you can imagine once you get started.
Bucket One: One Month’s Personal Living Expenses
Of course, this one month’s amount is going to vary dramatically from one person to another. Moreover, monthly living expenses can also fluctuate dramatically from one month to the next depending on what’s going on in our lives. This unpredictability is what causes some people to stop right here and give up dead in their tracks. Don’t do it. To help calculate this amount and create a new mentality to saving and spending, I’ll define essential living expenses below. Also, the simplest approach is to take your total expenses for the year (as best as you can estimate them) and divide it by 12. This monthly average accounts for the ups and downs in monthly expenses. Save that average amount each month and get the bucket going. This money should be in a separate bank account, or even a separate bank from your other accounts (if your self-discipline is lacking a little). Here’s the statement you may have trouble with: don’t worry about interest rates or investment factors. People are so trained to chase interest rates that they hesitate to simply have money available. Interest rates on liquid accounts are very low these days. Sure, 2 percent beats 1 percent, BUT just having available cash is more important. Just make sure it is accessible and liquid in the event of an emergency.
Bucket Two: Two Month’s Living Expenses
This is an additional two month’s of take-home pay in your savings and is on top of your first bucket. Thus, you will now have a total of three months of living expenses in reserve. Again, you can use an average of what this expense may be, and I encourage you to be generous. Fault on a little extra, rather than less. You won’t regret it. There is an ingenious way to slowly build these accounts by depositing the distributions from your business into savings first before paying your living expenses (note the section on false security below). This bucket will be in a savings account similar to bucket one. Again, don’t worry about interest or rates of return. This bucket has a far bigger purpose and benefit.
RANDY LUEBKE
It would be great, wonderful, and awesome if you could create the perfect budget, stick to it, and set up the exact, correct, ideal amount of money in reserve. However, having something is better than nothing—way better. So if you don’t have any savings today, get started saving something, anything. Conversely, do not overfund your cash reserves. Your money needs to make money to help you to achieve financial freedom. My point is that doing nothing is unacceptable. Regardless of the details of your situation, do not overlook or underestimate the power of doing this step correctly.
Bucket Three: The “It Depends” Reserve
At this juncture, with one month’s essential expenses pouring into the checking account monthly and two months net take-home pay in your savings, now we need to think about how much more money is enough to keep in your third cash reserve bucket. The amount of money you keep in this bucket will vary widely from person to person or family to family. That being said, it needs to be a significant amount. In fact, as an entrepreneur, this bucket will need to be much bigger, like six to nine months. This bucket may be funded with cash value life insurance. Yes, believe it or not, insurance can provide two or three ancillary benefits. There will be a death benefit, and the cash asset will be protected and guaranteed no matter what happens to your health.
Whatever your dollar amount needed to be to fill all three buckets, they need to be completely full BEFORE you save and invest for your retirement. In order to succeed in this process of the 4 × 4 Financial Independence Plan, and specifically the four sequential steps, these buckets need to be taken seriously.
What Randy and I have found is that our clients will fall into one of two categories at this juncture. There are those who have woefully underfunded their cash reserve accounts and those who have way too much money in their cash reserves. Obviously, both categories have their issues, and either way, you will have to make whatever adjustments are necessary. It’s important to step back and look at how you define the amounts of money in your buckets. You need to know what your living expenses truly are, how much you are actually saving and how much is necessary to cover your living expenses.
Personal Living Expenses and Lifestyle Expenses
Again, the key figure that drives the amount in your cash reserve buckets is your monthly living expense. It’s critical this number is close to accurate or as realistic as possible. However, we can sometimes look through rose-colored glasses and choose a budgeted amount that is too low or too high depending on our personality or temperament.
For most people, budgeting is painful. It’s like dieting or exercising but worse because if you are spending too much, you really don’t want to know about it. You just want to move on with your life and hope that somehow things work out. On the opposite side of those ignoring their budgetary problems are those who simply want to spend it all. Who wants to stop too much of a good thing? Frankly, I’m guilty of being on both sides of the equation. The solution to this quandary is implementing what is called “False Scarcity.” This approach breaks down all of our expenses into just two categories: essential expenses and lifestyle expenses. To do this, you need to recognize that not all the things you spend your money on are equally important.
Essential Expenses
These are for food, shelter, clothing, and health care. That’s it. That’s pretty simple, right? Food may be a little difficult to document 100 percent accurately, but you can keep receipts of all your food purchases, including dining out, for a few weeks to get a general idea of how much you spend in a given week on food. Next, you include how much you spend on rent, or if you own a home, how much your mortgage payment, property taxes, and insurance come to each month. Clothing is typically not something you buy regularly. Look through your closet and estimate how many items you have purchased in the past two or three months and roughly what the cost was for these items. This may help you guesstimate how much to put down. Health care, for most people, is fairly simple as the primary health-care expense is the cost of insurance, average monthly out-of-pocket expenses, and/or contributions to a HSA (Health Savings Account).
Lifestyle Expenses
These are expenses that need to be identified specifically and for which you need to save. We won’t buy things on credit except for productive debt, and thus, expenses to increase our lifestyle will only be incurred once our Three-Bucket System is in place and we are well on our way to investing in the fourth sequential step. Give yourself some silly money, or spending money, for small items in your essential expense line. If you don’t, you’ll go crazy and fail. We need to embark on this savings system with moderation and realism. Some families that are more frugal will accomplish this feat more quickly. Those that tend to be big spenders will need a little more time. Bottom line—find your essential expense monthly dollar amount separate from lifestyle expenses. Get to work and remember that close IS good enough.
The Transfer System and Creating a “False Scarcity”
First, let’s discuss the transfer process. As entrepreneurs, we are typically transferring the money we need to live on from our business account to our personal account. Sometimes, this is a constant and repeated transfer throughout the month as needed. Once you have your cash reserve buckets set up, you will transfer money from the first cash reserve bucket and then replenish it from your business as needed.
The beauty of the transfer system is to ONLY transfer from the cash reserve bucket to your personal account the amount that you think you need for living expenses, and maybe just a little for lifestyle expenses. Moreover, I want you to make just a couple transfers during the month. The goal is to create this feeling that money is scarce. This will prevent, or at least help you cut down on, spending too much on lifestyle expenses. With this method, you only see a limited amount of money in your personal account and thereby train your mind to believe that is truly ALL you have for the month. Even though it’s not true and there is more money in the business, you aren’t going to go and transfer it. By being self-disciplined, you will create a false sense of scarcity that the business doesn’t actually have more money to transfer (even though it does).
False Scarcity will evolve as you can only spend what you have transferred to your personal checking account from your cash reserve buckets. If you spend all the money you have allocated for your essential expenses, then you have spent too much. In sum, your business profits and any wages from a spouse or a side job will go into your bucket system of savings first. Then, your monthly essential expenses amount is transferred from your savings into your checking account. DO NOT deposit your business revenue, any earned revenue, into your personal checking account directly. This process repeated over time is what creates false scarcity.
Adjusting Your Monthly Transfer
After two or three months, it will become clear how much you need to maintain in your checking account to ensure that you can cover your essential monthly expenses. Think of it like the gas guage in your car and the goal is to pull into the gas station on the last day of the month on empty. Fill up your tank once a month. Drive around and try to refill your car on the last day of each month. Now, you can see why you don’t have to necessarily be 100 percent accurate with how much you are spending on any one of these essential items, although, you will develop an awareness of how much you are spending over time. Regardless of what has to happen each and every month, you will either have gas left in your tank (not the best outcome) it will be empty (the best outcome), or you are going to need to add more gas to your tank during the month (the worst outcome).
To summarize, as you start to recognize your needs from your wants and build these reserves, you quickly become addicted to the feeling of security rather than the feeling of consumption. The media, advertisers, and corporate America want you to be a consumer; in our plan, to find your freedom, you will become a saver.
Ironically, by becoming a saver, you will experience more wealth, more freedom, and more security. It’s a more natural and desirable feeling to be secure. Deep down, being a spender, without checks and balances, creates a feeling of insecurity and is irresponsible.
Freedom and wealth will start to permeate your life as you start to build cash reserves.
TAKEAWAY 1—Understanding the need for cash and having cash reserves with liquidity are cornerstones of your financial future.
TAKEAWAY 2—The Three-Bucket Cash Reserve system is a means of ensuring that you will have readily available cash that is safe and secure.
TAKEAWAY 3—The most important takeaway from this chapter is that you want to become a saver rather than a spender. Saving money in cash reserves will allow you to sleep at nights knowing you have cash available. It will also allow you to seize investing opportunities when they are right for you.