Your Financial CEO: Managing Free Cash Flow for a Wealthier Tomorrow

Published by Evan Louise Madriñan on 02/10/202302/10/2023

by elmads

Introduction

Our personal financial free cash flow is the amount of money that can be used for saving, investing, and leisure purposes.

The narrative changes if a person allocates his or her free cash flow to generate more money in the future, because that compounds the reinvested capital massively and, in turn, increases a person’s intrinsic value.

In my previous blog “Value Your Finances Like Valuing Assets: Putting Valuation in a Personal Financial Context”, we used Marcus as a hypothetical person to show the three case scenarios (worst, base, and best). I explained how we can make our own free cash flow projections based on our current income-generating capabilities, our priorities, plans, financial knowledge, skills, habits, and discipline.

In our Marcus example, we assumed that he would use his free cash flows, less debt, for saving purposes, while the rest would be spent on his family’s wants and leisure activities.

What happens if Marcus uses his free cash flow to generate additional income? Instead of using it for just stashing away money in a bank savings account, he uses a portion of his free cash flow, less debt, to make more of it.

From a business point of view, it’s using the company’s free cash flow to grow the business for the sole purpose of increasing its profitability. Either they invest it to purchase additional property, land, and equipment, hire more people, boost their marketing spending, for research and development, acquire another company, merge with another company, and others.

What I’m painting here for you is this: to look at your personal finances from a business perspective. Handling the cash flows is like having your own business.

You are the Chairman of the Board, the Chief Executive Officer, the Chief Operating Officer, and the Chief Financing Officer of your life. You have the control to make the best decision possible so that you can achieve the financial life you want for yourself and your family.

Therefore, for every free cash flow less debt you make for yourself and your family, you strategically use a portion of it to expand your financial fortress.

You are the Financial CEO of Your Financial Life: Manage your Free Cash Flow for a Wealthier Tomorrow

Costco Wholesale Corporation

Costco Wholesale is a big-box retailer and wholesale warehouse club. As the company states on their website.

“Costco is a membership warehouse club dedicated to bringing our members the best possible prices on quality brand-name merchandise. With hundreds of locations worldwide, Costco provides a wide selection of merchandise, plus the convenience of specialty departments and exclusive member services, all designed to make your shopping experience a pleasurable one.”

—https://www.costco.com/about.html

They are one of the best-operating big-box retailers worldwide. Their main source of revenue is membership. For every 1 million members worldwide, Costco generates at least $60 million in revenue from membership fees alone. As of early 2022, Costco had over 114 million cardholders. This demonstrates how vital membership fees are to the company’s bottom line.

Their membership grants different deals depending on the membership tier.

Currently the company has 859 stores globally.

https://www.visualcapitalist.com/number-of-costco-stores-by-country/

This is not specifically about Costco, but an overview of how we can use the concept of business analysis to improve our financial lives.

Costco’s Revenue and Net Income

From 2002 to 2023, Costco has been generating increasing revenue and net income.

In 2002, their revenue was $38.7 billion, while their net income was $699 million, with a 1.81% net income margin.

📝NOTE: To get the net income margin, divide the net income of the company by its revenue within the same period.

Today, in 20203, their revenue stands at $242 billion with a net income of $6 billion. Their net income margin is 2.60%.

📝NOTE: You might argue that their net income margin is miniscule, which is true, but you have to understand that big-box retailers always have low margins. It’s just the nature of the industry and the businesses in it.

Despite the low income margin of the company, their revenue still had a 6-fold increase, and then their net income shot up by 900% while their net income margin nearly doubled over the span of 21 years. That’s a feat of an efficiently managed business and a top-tier company.

The question here is: How did Costco do it? I know this is a broad question because this will require us to go back and review each year’s strategy taken by the management since 2002. This is an arduous task because it will require a lot of reading.

Nevertheless, we can still do this from a wider perspective without the need to delve deeper into Costco’s rabbit hole. This can be done by reviewing their financial reports.

In the past, this would also require me to get each year’s financial report, but since I’ve subscribed to Tikr.com, I’ve been able to shed off a substantial amount of time by getting financial data directly from the companies I analyse. The image above of Costco’s revenue, net income, and net income margin was taken from Tikr.com.

Costco Expansion and Cash Generation

“The company’s first location, opened in 1976 under the Price Club name, was in a converted airplane hangar on Morena Boulevard in San Diego. Originally serving only small businesses, the company found it could achieve far greater buying clout by also serving a selected audience of non-business members. With that change, the growth of the warehouse club industry was off and running.

In 1983, the first Costco warehouse location was opened in Seattle. Costco became the first company ever to grow from zero to $3 billion in sales in less than six years. When Costco and Price Club merged in 1993, the combined company, operating under the name PriceCostco, had 206 locations, generating $16 billion in annual sales.

Our operating philosophy has been simple. Keep costs down and pass the savings on to our members. Our large membership base and tremendous buying power, combined with our never-ending quest for efficiency, result in the best possible prices for our members.”

— The History of Costco, https://www.costco.com/about.html

Costco has always stayed true to keeping its prices low, and they do this by making sure that they don’t put a large premium on their sold products (usually only less than 12%), while their competitors are selling at more than a 20% price premium on goods sold. This is made possible because Costco sells items in bulk. The company makes a conscious choice to prioritise customer satisfaction over short-term profits. This business model and their strategy proved successful, as a lot of buyers from all walks of life go to Costco and purchase their membership cards.

Below is an oversimplified bird’s-eye view of Costco Wholesale throughout the years.

✨A great business model that prioritises customers (sells items at low prices compared to competitors and sells them in bulk) > increases customer demand > increases supply by opening a new store

This is mostly supply- and demand-driven, but as I’ve written above, this is only an oversimplification of what happened to Costco over the years because there are nuances to what makes it a great business. The warehouse experience, product placement, their suppliers, the remaining 20% of revenue drivers that are not membership-driven, their return policies, their employee retention rate, their customer loyalty, their service to customers, the management, their continued focus on upholding the company’s philosophy since day one, and a lot more

Let’s go back to its financials, shall we?

The company has continued to thrive these past few years. They’ve been able to expand by opening new stores.

From 2005 to 2023, their stores/warehouses doubled from 433 to 859. One of their drivers of growth is the store opening. They were able to capture new customers while retaining loyal ones in different parts of the world. See Image below taken from https://en.wikipedia.org/wiki/Costco

And to open those new stores, they require capital. Guess where they got the capital? It’s either through their free cash flow and cash on hand, acquiring debt, selling more shares of their business via the stock market, or a mix of the three. See image below.

I’ve discussed this in detail in my blog titled “📣The Capital Markets: Exploring the Dynamic Relationship between Public Companies and Investors”.

It is estimated that Costco spends approximately $100–$400 million on every store they open. That store becomes a property, plant, and equipment asset, which will generate them additional revenue in the future, provided it is well managed. Not all stores will do well; some will do poorly, while others will do well.

They did these for decades, and it showed in their income statement. Via the relationship between the growth of their equity and net income. 

As shown above, every time Costco invests a portion of their cash flows for opening a store or other business endeavour that is related to growing the business, the equity side of the company (where assets minus liabilities) also increases. If their investments were done thoroughly, both from a financial and business operations point of view, then the returns from the initial investment would have been the beautiful fruit of their labour. That’s what happened with Costco Wholesale Corporation.

📝NOTE: The story differs if the growth of net income is generated more by debt, meaning the cash used to open the stores in the past was raised through debt. If the liability side is higher than the asset side of the company, then its equity will be in the negative.

All of what I’ve explained here can be summarised in two financial metrics, return-on-equity (ROE) and return-on-invested capital (ROIC), which I’ve explained in detail in my blogs that I’ll link below.

📣 https://elmads.com/?p=7019 – Return on Net Worth & Return on Equity

📣 https://elmads.com/?p=8657 – Return on Invested Capital

A low ROIC and ROE could indicate, but not exclusively, poor financial investment and/or poor run operations.

Costco Wholesale Corporation to Personal Finance

🔝Revenue is Gross Salary

⬇️Net Income is Net Salary

💰Free Cash Flow is Free Cash Flow

♎Equity is Net Worth

A business usually handles money in the millions to multi-millions, while an individual is at around tenths of thousands to hundredths of thousands. Other than that, there’s not much of a major difference when analysing their cash flows.

The fundamental concepts of cash flow analysis will always guide us in understanding priorities and goals, regardless of whether it is personal, corporate, or public finance.

Now here we go back to personal finance. What happens if you learn how to make your money work for you? What would be your personal intrinsic value? I’ll tell you now that it would be larger than it certainly is now.

The architects who efficiently and strategically handle their cash flows in sync with their financial goals will be able to create their individualised financial fortress.

Just like with Costco Wholesale Corporation. Their massive growth, both on the financial and operational sides, wouldn’t be possible if they didn’t have a good business model that understood and provided for the needs of their customers, if the management didn’t handle their operations well, and if they didn’t manage their capital efficiently.

If Costco didn’t possess the three things I’ve listed that contributed to their growth, then the tabular graph, column and line combo graphs wouldn’t be possible. Every time they open new stores, their revenue per warehouse and net income per warehouse will not reach such an amount.

If the company doesn’t manage everything well, both on the operations and financial front, then they wouldn’t be able to increase their employee count. Not all investments would guarantee a return in the future; in Costco’s case, increasing the number of stores and hiring more employees do not translate to increased profitability, yet they still do. Just look again at the profitability per number of their warehouses.

In some other retailers, increasing their store count results in a larger increase in operating costs than their net income, which is reflected in the net income margin.

Relating Costco’s cash flow to personal finance.

The cash from operations that Costco produces is used for maintenance of their assets and purchasing and/or making new assets; the remaining amount can be used for paying debts, future reinvestments, acquiring businesses, and/or merging with other companies (if deemed essential by the management).

The process of opening new stores is an investment decision, where they’ll shell out money for it. Their investment has no certainty of a 100% return; it can either grow the company by adding more profitability or hinder its overall growth by further increasing its cost basis than its income.

The newly opened warehouses by Costco will now become an asset that generates additional income flow.

In conjunction with our finances, the moment we receive our income, we deduct all of the costs needed and arrive at our personal financial free cash flow. That money can be used for investments such as starting our own business, rental property, or owning stocks, to name a few. These investments will now become part of our assets and net worth, which generate income for us.

The income generated by our assets is an additional income stream, either dividend, rental, or interest income, depending on what kind of asset we have invested our capital in.

Understanding How to Expand Your Financial Fortress

Recall that your personal intrinsic value is not your wage or your net worth, but the synergy of these two plus your financial knowledge, skills, and habits.

A portion of your saved income builds your net worth, then your net worth eventually supplements your income and in turn expands your own free cash flow.

Do you still remember Marcus? Our hypothetical example I’ve used in my previous blog “Value Your Finances Like Valuing Assets: Putting Valuation in a Personal Financial Context”. I’ll use him again in our succeeding examples from this point forward.

Let me paint the picture here again.

• Marcus works as a physiotherapist in a hospital, has a family with a child, rents, and has a car loan.
• The base year is 2024, and his expected net income is worth £26,000, which would increase by 1% a year up until 2033. His cost of living and maintenance expenses in 2024 would be estimated at £20,000 and would also increase by 1% every year for a 10-year period.
• Marcus’ would fully pay his car loan by 2027. Our assumptions about Marcus’ 10-year predicted financial cash flow will look like this; see below.

Think of it as the income statement or cash flow statement of Marcus, which is similar to what I did with Costco’s.

If Marcus doesn’t save and/or invest a portion of his free cash flow after deducting debt, then his cash flow chart would look like this:

Sadly, if this continues over a long period of time, Marcus would probably need to work his entire life to sustain his and his family’s lifestyle.

Saving and investing are not required, provided that Marcus will be able to find ways to make money to sustain his and his family’s basic needs and discretionary spending.

For most people, that is done by exchanging their precious time and effort in for money, but for how long will the body be able to keep up with their lifestyle? That’s always a question that no one will be able to answer, but can only be mitigated by preparing for it as early as possible. It’s as simple as being realistic and pragmatic about life.

Nevertheless, if your company would support you with a lifetime pension—an amount greater than 70% of your yearly income when you worked with them— then that would be wonderful. Realistically speaking, only a few companies do that.

Saving A Portion of Your free Cash Flow

If Marcus is future-oriented, then he would somehow save a portion of his free cash flow for future use. The flow chart above shows a simple cash flow chart where saving money is included in the budget.

It starts with employment income, which is received in the form of gross pay, and then deductions occur as indicated in numbers 2, 3, and 4. The left-over free cash flow for savings now goes to a savings account for savings purposes.

📝NOTE: Taxes and other pre-tax deductions are not included in the chart above, but they are an expense that always takes place before we receive our net salary. I’ve written about this in detail in my blog titled “📣Financial Mutant Level of Managing Money – Your own Income Statement”

That saved money in a savings account would now be an asset for Marcus (number 5). This asset would would generate him an interest income (number 6). The interest generated is considered a cash inflow, regardless of the amount received (number 7).

Marcus now has a choice about what to do with it: either leave both the initial capital placed in his savings account, including the interest income received, or withdraw a portion, if not all, of the amount in the account (number 8).

This cycle can either continue or not, depending on Marcus’ decisions moving forward, his financial priorities and responsibilities, and its possible changes.

What if instead of just stashing away a portion of your hard-earned money in a bank savings account, you invested it?

Investing your free cash flow like a business invests to expand their empire through strategic management and the acquisition of assets.

Before we get there, let’s first understand the income flow chart relationship between our income and net worth. How the virtuous cycle of money happens in personal finance.

Investing A Portion of Your Free Cash Flow

Investing a portion of your cash flows means purchasing an asset or assets to generate more income for the future. This can take the form of marketable securities (stocks and bonds), real estate, or having your own business. Though this may seem like a very lucrative endeavour to further increase our income flow, we still have to be aware that it carries a risk of permanent capital loss. It just seems like a fair price to pay, if you ask me. This is the reason investing shouldn’t be taken lightly; it should be approached with not just hopes and optimism but with the purpose of understanding the fundamental aspects of investing.

A person doesn’t require a high level of intelligence to understand it, because capturing the average returns of the investment world is achievable for everyone who takes this path.

Nevertheless, before a person can even be able to invest a portion of their income, they first need to have excess cash for investment purposes. That’s where your free cash flow will come into play. Let’s just say you already have the capital less all of your cost-of-living expenses and debt payments. You then decided to use a portion of your free cash flow for investment purposes.

The flowchart above will show the flow of your income. (form numbers 1 to 9).

To understand how this works, let’s use Marcus’ 2024 and 2025 projected cash flow statements, starting with fiscal year 2024.

Marcus’ 2024 Free Cash Flow Chart

1. Employment income received starts with gross salary, then taxes and other deductions will occur, giving Marcus’ net income.
   .
2. Essential spending plus maintenance expenses will be paid. This is Marcus’ cost of living. This is an immediate cash outflow, as it provides the basic necessities of life.
   .
3. Debt and interest payments. This is a cash outflow that I consider an immediate expense because the longer you don’t pay the principal on debt, the more interest payments will accumulate over time and the larger they will be. Interest on debts becomes a heavy burden because it utilises the power of compound interest. To learn more about the power of compound interest and why it is called the 8th wonder of the world by Albert Einstein, see and read the blog links provided below.
   
   📣 Simple and Compound Interest
   📣 Simple and Compound Interest and the Net Present Value of Annuity & Life Insurance
   📣 Debt is not Good, nor Evil
   .
4. What is left after numbers 1–3 have occurred is our personal free cash flow. The excess cash we can use for discretionary spending, savings, and investments. Why do I call this a non-immediate cash outflow? It’s because this money can be spent either today or in the future for a purpose that we deem important for ourselves and our family.
   
   You can save a portion of your free cash flow for this year in a high-yielding savings account to be spent next year on your European tour. Or, invest a portion of your salary consistently for 10 years, then use the principal investment plus all of its gains to purchase a home or a luxury watch.
   
   This is where most people get confused about money management. They think that saving and investing money don’t coincide with spending. when, in fact, they have a strong relationship with each other.
   
   Remember this: money saved and invested are delayed gratification strategies to attain a goal in the future that you deem more important than other things today. What I mean here is that no amount of money invested and saved will stay that way forever because money’s purpose is for exchange, so it’s for spending purposes.
   
   What distinguishes efficient people from money-misers and spendthrift individuals is their prioritisation and self-awareness. Even if you level the playing field, where financial knowledge and skills are all equal, the former will still do better in terms of money management than the latter two (money misers and spendthrifts).
   
   What I’m saying is that saving and investing money and delaying gratification can be used for leisure spending in the future. You just really need to learn how to prioritise things.
   
   Delayed gratification and prioritisation tell us this. “You can have anything, but you can’t have everything”.
   .
5. This is the portion of your free cash flow saved, invested, or both. In Marcus’ example, he plans to invest a portion of his salary in a low-cost ETF. The FTSE All-World UCITS ETF that tracks the performance of the FTSE All-World Index (the “Index”). The projected amount he’ll be able to invest in 2024 would be £2,000.
   
   That amount of money that he’ll invest will now become part of his net worth. At the start of 2024, Marcus’ still doesn’t have any savings at all and has no debt; therefore, his net worth would be £0.
   
   📝 NOTE: In reality, individuals should have first established an emergency fund worth 3-6 months of their essential expenses, a rainy day fund for maintenance expenses, and life and medical insurance. A fortress will not flourish if its defences are weak and fragile; therefore always start by fortifying your financial fortress. 
   
   📣 https://elmads.com/?p=484 – Basic Financial Planning “Part 1”
   📣 https://elmads.com/?p=546 – Basic Financial Planning “Part 2”
   
   At the end of 2024, Marcus invested a total of £2,000; this would reflect on his total assets, but his net worth would be in the negative because he took a car loan worth £12,000 by the year end.
   
   This would still give Marcus a negative net worth because his liabilities (£12,000) exceed his assets (£2,000) at the end of 2024.
   .
6. The asset of Marcus, in this case, the £2,000 he invested in an index fund, would generate dividend income and/or capital gains (if he sold at a gain).
   
   In Marcus’ cash flow chart above, his investment hasn’t generated yet any income because he invested the total of £2,000 at year-end. The bulk of his dividend and possible capital gains would be generated the year after.
   .
7. Cash flow. The total gains he’ll get from his investment would be categorised as investment income, which would be an additional income flow.
   
   The taxes for dividends and capital gains are different for every country, and it also depends if you’re a resident or foreign investor.
   .
8. Once the investment gains are received, the question here is: how will you use them? Will you spend it immediately? Or will you reinvest it?
   
   Same as with Costco, if you want to expand your business, generate cash, and increase your profitability, then you definitely need to reinvest the cash flows you received within that year. If you want to increase your net worth and, in turn, boost your income flow in the future, then reinvesting your investment gains would be a prudent choice, provided that they are still in sync with your financial goals.
   
   Or they can distribute their income to their shareholders via dividends or stock buybacks. From a personal finance point of view, that’s spending to pay bills, debt repayment, discretionary spending, or a mix of the three.
   
   Or they can do both: reinvest and distribute portions of their free cash flow.
   .
9. Reinvest. Marcus’ chooses to reinvest all of his gains because his priority is to expand his net worth.
   
   In our flow chart above, I only focused on Marcus’ total asset worth to make things less complicated. Thus, in fiscal year 2024, Marcus’ total asset worth will be £2,000.
   

This cash flow chart above only shows the fiscal year 2024. What do you think will happen to Marcus’ total assets at the end of 2025 once his £2,000 investment in 2024 generates income for him the year after?

Marcus’ 2025 Free Cash Flow Chart

Marcus’ net income and essential expenses both increased by 1% from from 2024 to 2025 (see numbers 1 and 2 cash flows).

He also decided to allocate a substantial amount of money for paying his debts (cash flow number 3), then decided to allocate £1,000 for the family’s wants (number 4), then £320 for investments (number 5).

At the start of 2025, Marcus’ total asset worth was £2,000, which was the total amount he invested in 2024.

That £2,000 he invested generated a 7% return, worth £140 (number 6). This amount would then become part of his total net income (number 7).

Marcus’ Projected Net Worth

The left image is if Marcus saved his free cash flow in a high-yield savings account, while the right image is if he invested it in the FTSE All World ETF.

Clearly, investing his money would give him a larger amount of money. That said, your financial goals must always be in sync with your money management. What I follow is this:

I save a portion of my free cash flow in a high-yield, easy-access savings account for my financial goals that are within 3 years. For 3–10 years, I place a portion of my free cash flow in bonds or savings accounts with higher returns that have a time-specific lock-in period, and lastly, I invest a portion of my free cash flow in stocks for my financial goals that are timed for more than 10 years.

For Marcus, his financial goals are tied to more than 10 years; thus, he projected that he would invest his free cash flows in an ETF. His projected net worth at the end of 2033 would be worth £19,807.52 based on his forecast of his cash flow investments from 2024 to 2033.

Will that be enough, though? Well, we only projected 10 years’ worth of his investments. The question is if Marcus will be able to continue the habit of investing, managing his money, and expanding his income from 2033 onwards.

We can estimate his intrinsic value today based on our projections of his cash generation capabilities in the future. We’ll do it via discounted cash flows.

Marcus’ 2024–2033 projected personal financial statement and asset worth, cash flow chart

Everyone can do this, yes, even you, but before you can do your own projection, you have to consistently record your current income and spending patterns.

📣 https://elmads.com/?p=1444 – Financial Mutant Level of Managing Money – Your own Income Statement
📣 https://elmads.com/?p=1472 – Financial Mutant Level of Managing Money – Your Own Net Worth
📣 https://elmads.com/?p=1483 – Financial Mutant Level of Managing Money – Your own Cash Flow

By forming the financial habit of consistently recording your current cash inflows and outflows, you’ll be able to make your own financial data sets. This will substantially aid you in forming your own future financial projections for worst-case, base-case, and best-case scenarios.

Remember, you don’t decide your future. You decide your habits, and your habits decide your future.

Marcus’ Financial Intrinsic Value

The financial intrinsic value of our financial habits is based on our earnings capabilities and money management.

It is the present value of all the future cash flows that we could generate.

The Free Cash Flow columns written on the tables above (if saved and if invested) are: 1.) the free cash flow amount was taken from Marcus’ income after all deductions (essential spending, maintenance expenses, debt, interest on debt, and discretionary spending); and 2.) the reinvested income generated by Marcus’ savings or investments in a specified year.

📝NOTE: If you’re wondering how I arrived at the estimated intrinsic value, Please see the following blog links down below.
📣 https://elmads.com/?p=11250 – A Dollar Today is Worth More Than a Dollar Tomorrow – The Time Value of Money
📣 https://elmads.com/?p=11316 – DCF Valuation: Unveiling the Secrets of Intrinsic Value Calculation
📣 https://elmads.com/?p=11555 – Investor’s Toolkit: How to Identify and Utilize Risk-Free Assets
📣 https://elmads.com/?p=11628 – Investor’s Toolkit: Using the Risk-Free Rate for Better DCF Analysis
📣 https://elmads.com/?p=11676 – Value Your Finances Like Valuing Assets: Putting Valuation in a Personal Financial Context

The second image above is a waterfall chart showing the total cash inflows and outflows projected for Marcus from 2024–2033.

Marcus’ total invested amount at the end of our 2033 projection was £15,142.21. This translates to a savings rate of only 5.56%, which is below the UK’s national savings rate of 7-8%.

The savings rate is computed by dividing the savings or invested amount by net income.

To Sum It Up

Approach personal finances with a business-like mindset. The central idea revolves around how managing and investing your free cash flow can lead to significant financial growth. I illustrate this concept through a hypothetical individual, Marcus, who makes financial decisions about saving, debt, and investments.

Your salary is not your net worth. Understanding the distinction between your salary and your net worth is fundamental to building a strong financial foundation. Your salary is the income you earn, but it’s not a direct reflection of your financial health. Net worth, on the other hand, represents the value of your assets minus your liabilities. It’s a measure of your true financial standing.

By comprehending the importance of both your income and net worth and how to manage them effectively, you can make informed financial decisions, save, invest, and ultimately construct a robust financial fortress for yourself and your future. These financial insights are essential for achieving long-term financial security and prosperity.

By practicing sound financial management, including strategic saving and wise investment, you can substantially enhance your financial well-being and intrinsic value. Have a forward-thinking approach to your financial choices that aligns with your financial objectives.

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.