Stop Worrying About Your Net Worth –
Start Looking at Your Cash Flow Instead!
People obsess about net worth in the media, but I’d like to introduce you to a much more important concept in personal finance: cash flow.
To be honest, net worth is really just a number, while cash flow is a much better indicator of an individual’s or household’s financial health.
In fact, I would even go so far as to say that net worth is an outdated concept. Whether you’re a middle-class individual or a large business, net worth has practically no predictive power. It’s just an indication of what you have now, as opposed to how much you’re likely to earn in the near future. That’s why banks hardly use net worth as a factor in deciding whether or not to give a loan and how much they’ll be willing to lend.
Besides, cash flow tends to lead net worth: if one’s cash flow increases, so does your net worth in most cases. The opposite is also true: when cash flow declines, net worth tends to follow. And in regard to the value of a company, current cash flow can be measured against cash flow in the recent past, thereby providing a reasonably clear indication of the ongoing financial health of that company. Net worth simply can’t provide that kind of big-picture indication.
Furthermore, when investors are assessing the value of a company to possibly invest in, they’re usually not using net worth (which sometimes comes in the form of “book value”) as a major consideration. Instead, they’re calculating capital influx (how much money is coming in) and expenditures (how much money is going out). In other words, it’s cash flow they’re really interested in.
On an individual level, you really need to be more concerned with your cash flow than your net worth.
Think about it: you wouldn’t pay your living expenses out of your net worth, would you? You might try this for a little while but you’d deplete your savings and end up completely broke pretty soon. Therefore, it only makes sense to pay your expenses out of your cash flow whenever possible.
Cash flow is the key to success.
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As an individual, cash flow enables you to pay yourself on solid financial ground. And as an investor, I always check the cash flow of a business as a barometer of financial well-being.
That’s because when a company has a consistent flow of capital coming in, that enables the company to pay dividends to investors. It can also allow the company to invest in new facilities and equipment or even acquire other businesses, thereby augmenting the company’s cash flow even further. Best of all, if these objectives are achieved through positive cash flow, the company doesn’t need to tap into their net worth at all.
Effective financial management actually means using one’s net worth to generate cash flow. On an individual or household level, that could mean wisely investing what you already have in order to generate more capital. That’s why I’m an advocate of investing in solid, well-researched companies: when they have consistent cash flow, you probably will as well if you invest in those companies.
Other ways to convert your net worth into cash flow include collecting rent on real estate holdings, investing in interest-bearing assets, and collecting payments on micro-loans. In contrast, there may be components of your net worth that generate no cash flow whatsoever, such as your personal automobile, entertainment equipment, or non-antique/non-collectible furniture.
Personally, I believe in having as many cash flow vehicles in my net worth as possible. If I can have most of my assets generate more assets, I’m achieving an important financial goal: making money while I sleep. After all, if your only method of increasing your cash flow is working longer hours at your job, you’re really limiting your income potential.
I’m not advising that anyone should completely ignore their net worth, as it is a piece of information that has its place in one’s personal financial plan. Just make sure that you’re aware of your cash flow – and while you’re at it, look for ways to improve your cash flow, which will improve your financial situation.
P.S. While my wife was reviewing our 6-year-old daughter’s school work last night, we noticed something very special she wrote down when she was asked to write her favorite things (check out the green balloon).
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Legal Notice: This work is based on SEC filings, current events, interviews, corporate press releases and what we’ve learned as financial journalists. It may contain errors and you shouldn’t make any investment decision based solely on what you read here. It’s your money and your responsibility. The information herein is not intended to be personal legal or investment advice and may not be appropriate or applicable for all readers. If personal advice is needed, the services of a qualified legal, investment or tax professional should be sought.