Why cash flow is the building block of wealth
DISCLAIMER:
I am not a financial, investment or legal advisor. All views expressed in this article are only that and nothing more, just my views, and their only purpose is to entertain you. Do not take financial advices from random guys on internet. Always talk to a certified advisor.
When it comes to personal finance, most people always focus on maximizing their wealth (or what we officially call, the Net Worth) instead of maximizing their Cash Flow. However, this is one of the biggest mistakes anyone can make in personal finance management and I am going to analytically explain why.
First of all let’s begin by defining these 2 terms.
Net worth = Total Assets — Total Debt (at a given moment)
Cash flow = Cash Income — Expenses (in a given period of time)
I think that the difference between them is quite clear, but let me explain it even better. Net worth is a metric of your wealth at a given moment while cash flow measures your income vs your expenses during a specific period of time.
Trying to maximize net worth can either mean to minimize debt or to maximize the value of total assets (or do both).
Minimizing debt is crucial in order to reach the so called “Financial independence”. In fact paying of debt is like investing in something that it offers a guaranteed return (on the rate of the debt’s interest). So this is where I would start from in order to reach financial independence.
And what about the first part of the equation? Here is the main trap someone could easily fall on: Maximizing the value of assets does not necessarily mean that you can further use this added value immediately, and thus this added value misses any compounding effect it may have. It may also ruin your financials because many times the added value of net worth, is not coming in form of cash. And cash is very important because it is what mainly covers expenses and needs.
A practical example
Here is an example: Let’s say a family owns a house in a nice district and it bought it for 250,000$. Both parents of the family work but they have no other income sources (aka cash flow) so they live from paycheck to paycheck. After 10 years, the value of their house has raised to 270,000$ due to further development of the district. So technically their net worth has raised to 270,000$ but they cannot use the difference to benefit or reinvest it unless they sell the house. Actually sooner or later, they may need to sell it in order to cover immediate needs due to their low cash flow. Selling the house will gradually reduce their net worth, as they will surely use the cash in order to cover other needs.
But, if they had more cash flow from other activities, i.e from other houses that they may rent, from stock dividends or from a side hustle, they could use these money in order to cover their immediate needs and thus preserve their house and net worth. And if they are enough frugal and build a well-documented financial plan they could even use the excess of their cash flow in order to reinvest this money and create more cash flow that will finally lead to more net worth and wealth.
In conclusion
I believe this example explains pretty well why cash flow is the building block of wealth. So stop focusing on maximizing net worth and start thinking about new income streams in differentiated sectors. Then, reinvest this cash flow and the compounding effect of your money will surely reward you.
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