In this article, we are going back to the basics. This topic is not complicated or advanced, but it is incredibly important. And, it can all be summed up in one sentence: without positive cash flow, it is impossible to build wealth.
When I was a financial advisor, people would open up their financial lives to me. They would show me their pay stubs and their bank statements. We would look at their investments and their debts. The goal was always the same: to help them build a financial plan.
But, something else happened. I started to see patterns.
I saw families that were making six-figure incomes that were barely scraping by. And, I saw families that were earning at, or below, the median income (around $50,000 per year), that had strong savings and investments.
For example, there would be families making $10,000 a month (after taxes) that would ultimately lose their home if they missed one paycheck. And, there were other families that were making $3,000 per month that had a nice emergency fund, some investments, and surprisingly, less stress about money in their lives.
The primary reason that those high-income families were struggling was that they were confusing cash flow with wealth.
This led to one of the most important realizations of my financial life:
Cash flow is more important than wealth.
What is Wealth?
Wealth, also referred to as Net Worth, is what you would have left if you added up all of the things you own (assets) and subtracted off all of the things you owe (debts). Wealth is measured at a point in time. For example, Mark Zuckerberg had a net worth of about $71 billion in 2018. Yes, that is a 71 with nine zeros after it. $71,000,000,000. That’s a million dollars… times seventy-one thousand. Seventy-one thousand million dollars.
Each of us has a net worth. For some it is positive, for others it is negative. You can calculate yours. Just add up everything you own and subtract off everything you owe.
The important thing is that wealth is a single number at a specific point in time.
Think of Scrooge McDuck. He has his wealth in gold coins that he holds in a money bin. When you add up your net worth, you can imagine it stacked up in coins or hundred dollar bills.
Because wealth is a specific number at a specific time, it is static. It is just a pile of assets (or debt).
What is Cash Flow?
Cash flow, on the other hand, is fluid (just like the name implies). Instead of being measured at a specific point in time like wealth, cash flow is measured over a period of time. Cash flow is your income, minus expenses, over a set period of time.
If your income is more than your expenses then your cash flow is positive, which adds to your wealth.
If your income is less than your expenses then your cash flow is negative, which reduces your wealth.
Let’s look at an example to try to separate cash flow from wealth:
- Let’s say you started 2018 with a net worth of $10,000;
- During 2018 you earned $50,000;
- During 2018 you spent $45,000;
- Therefore, by the end of 2018, your net worth had increased by $5,000; and
- At the end of 2018, your net worth was $15,000.
Money flowed in. Money flowed out.
And, because more money flowed in than flowed out over the course of the year, your cash flow is positive and you now have more wealth than you had before.
Positive Cash Flow is the Building Block of Wealth
Without positive cash flow it is impossible to build wealth. And, negative cash flow eats away at wealth.
Let’s go back to Scrooge McDuck. It does not matter how big that money bin is, if he takes money out but does not put money back in for long enough, then someday he will definitely go broke.
I guess that’s why he’s spending his retirement running all over looking for treasure.
The power of money is not in how big of a pile you have. The power of money is in how it flows through your life.
For example, let’s look at a million dollars. Let’s say you retire at 65 with $1 million in wealth. If you are Scrooge McDuck you have it all in your money bin, where it is super safe, but it is not invested and it does not earn dividends or interest.
If you spend $50,000 per year, you will have 20 years until you are broke. So, you’d better hope you don’t live past 85. If you put your $1 million wealth in a money bin and just let your negative cash flow eat away at it, soon it will be gone.
However, if you invested your $1 million it is possible to create a portfolio that generates 5% of income every year. That means the $1 million would be creating $50,000 per year.
So, if you retire at 65 with $1 million in wealth that creates $50,000 in income, and you spend $50,000 per year, then at age 85 you will still have the million dollars! (Plus or minus any changes in share prices). If you want to learn more about how to make that happen, check out my article about it.
No matter how big your wealth is, if your expenses are more than your income, someday you run the risk of running out of money. But, if your expenses are not more than your income, then you will never run out of money, and you will likely have more wealth at the end of retirement than you had at the beginning.
A lot of financial advice says that you should start saving early, even if it is just a few dollars per month. Those early savings are not going to make you rich. But, it will get you into the habit of having a positive cash flow. You will see what it feels like to watch your wealth grow. And, that will make you want to see it grow more.
I have been able to have a positive cash flow every single year since I graduated from college in 2002. And, that includes 2005 and 2006 when I went back to graduate school. Sure, I had to significantly change my spending habits during those two years because my income dropped dramatically.
The most important piece of financial advice I can give you is to do your best to have positive cash flow every single year.
It is not reasonable to try to have positive cash flow every week or every month. Sometimes, you just have to make large purchases.
But, if your family makes $50,000 per year, then don’t spend more than $50,000 per year.
I know, that’s not very sexy advice. It seems pretty self evident. But, it needs to be said. Every single family I have ever worked with that is struggling financially breaks that rule occasionally… or even regularly.
If you want to be wealthy, make sure your cash flow is positive.
For a quick way to jump start the process, you can read about my undetailed budget process.
I hope this has been helpful! I welcome your comments with your thoughts and questions.