Stock and flow are alternative ways to look at – and control – your money. Even if both are important, it’s key to understand these concepts to obtain a deep understanding of your finances. We have explored in previous texts a number of different angles of Finance and FinTech, and this aims at explaining this simple and fundamental question: when are you looking at stock and when is it a flow of funds.
The easiest way to think of the difference between flow and stock is to step out of the finance discussion briefly, and think of something mundane from your daily life, say water for instance. Let us imagine you would put one liter of water in a large basin every hour, and never drained it – let’s assume no leaking nor evaporating either. For the first period you calculate, take one day as an example, you will have poured a total of 24 liters, and at the same time you will end up with exactly 24 liters in the basin.
Now, regardless of you continuing to pour water at the same pace, the following day already starts with 24 liters, so if you continue for one more day to include one liter per hour, you will have added 24 liters on this second day, but the total accumulated water will now be twice as large, of 48 liters. This silly comparison can inform in the simplest of terms how flow – the sum added to the total during the selected period – differs entirely from stock – how much you have at one given point in time.
Bringing it back to finances, let us look at what this means in terms of your personal budget and controls.
In personal finances
Every time we get a statement summing or subtracting amounts your account, this refers to flow. From salary plus other income you might have, to expenses and investments reducing the amount of funds on your account, these transactions represent movement and are similar to the water being poured into (or taken out of) the account. You may note that the flow will generally correspond to a certain period of time, like a month or a year, in which the transactions happen.
Stock on the other hand corresponds to the final balance at the end of a period. Regardless of which type of account you have and in which currency you transact, at the end of a given month you will have a final assessment of how much is available at a given account, as well as if it is a positive (creditor) position or if you have a negative (debt) balance. Stock, in this case, is more similar to a(n amount) picture of a given moment, so it will have the precise date when the positive or negative value was observed, not a period.
Please note that it’s harder to describe high flow of funds than a large amount of debt or assets. Within the flow, you will have incoming and outgoing transactions, which might or might not balance a given budget. Someone who has large income, but a much lower level of expenses, will over time form a stock of funds – savings or assets in general. Reversely, a high level of expenses without corresponding income means burning savings or increasing indebtedness over time. This means that the while flow and stock are different in essence, they sure are connected since the flow is constantly influencing future stock.
Legal entities also have to look at flow and stock of funds, so knowing which refer to stock and which to flow is key to understand the financial situation you are looking at.
Take a company’s financial statements and the different documents you find in them. One can easily distinguish flow from stock, since they displayed separately. Profits and Losses (often called P&L) is a control that starts with how much has entered the organisation in the form of income during a certain period, goes on to deduct all the expenses incurred, and concludes with how much profit or loss the organisation has made. The balance sheet, a very different sort of control, details the stock of debt, equity and assets the company has at the end of the period. It is worth noting that profits/losses are flowing each given period, but also accumulates over time forming a stock, so that is the specific number that goes from the flow to the stock.
Should you wish to see a real example of this, please get in touch and I’ll be happy to show you a case, they are easy to come about and understanding is much better over real numbers.
Domestic and national accounts
When it comes to news regarding national and domestic accounts, there is a myriad of numbers being published, and while basics of a country’s domestic accounts are similar to a company or an individual, the dimensions are large enough to confuse a first-time reader. The widely known Gross Domestic Product – or GDP – corresponds to how much an economy has generated over a certain period of time, therefore we are looking at a flow amount. If you look up one among many common descriptions, such as on investopedia, the GDP is considered the best indicator of how healthy an economy is, which for me sounds a lot like you are looking at the state (stock) rather than it’s recent development (flow), but this is an imprecise interpretation.
Well, for a Brazilian national like myself, how much the economy grows in a given time period does not necessarily reflect the economy’s health since we have experienced so many economic ups-and-downs that it almost seems discretionary to pick a period. Much more interesting to compare countries and their respective economies, in my view, is the stock of the most relevant long-term indicator of their future income from abroad – foreign direct investments.
One final point I think is often a relevant bias in the GDP numbers is the importance of foreign nationals, as well as the economic output of nationals in other countries. The measure of the Gross National Product (GNP) should consider exactly what nationals from one country produce – regardless of being based domestically or abroad – and an assessment of this number together with the stock of foreign direct investment can constitute a much better assessment of a country’s economic strength than just the GDP, in my view.
To sum up, if you want to know your numbers, whether you are looking at your personal finances, a company or a country, please make sure to consider if they are flow or stock types. Bear in mind that someone whose monthly budget indicates a large flow, but holding little stock, is in a very different position of someone who has large stock, but with little ongoing budgets. Consider those fundamentals to assess where you are with your finances and direct them where you want to be.