Cash Flow or Net Worth: It’s Comparing Apples To Donuts
Should you measure your investing success by cash flow or net worth? I think the answer to this question depends on your investing goals.
For anyone who plans to retire early, cash flow is extremely important. I want to explore the advantages of investing for cash flow, and talk about my personal reasons for treating cash flow as my primary metric for investing success.
For the sake of argument, I want to set up a scenario that we can reference.
Would you rather have:
- $1.2 million in stocks (growing at 10%)
- or $10,000 per month passive cash flow?
If the stocks are growing at 10% then your net worth would grow at about $10,000 per month.
We’ll assume that the cash flow is magical and you have no net worth aside from.
I’ll say, I do prioritize cash flow over net worth in my investing, but if I could pick between these two options, I’d take the $1.2 million in stocks. You’ll see why.
Cash Flow Is Mandatory
First, it’s important to understand that a person cannot financially survive for long with negative cash flow. You need cash to pay for the essential items in life.
Let’s say you have that retirement fund that is worth $1.2 million and you’re 45 years old. I mean that’s impressive, but if you have no way of making money from month to month, then that $1.2 million doesn’t look quite as nice. You’ll have to start withdrawing money from that account to survive.
You’re retirement account may continue to grow, but it won’t be growing very fast.
But if you had nothing saved up and had a positive cash flow of $10,000 per month. That’s only $120,000 per year and it would a decade to save up $1.2 million. But that positive cash flow will provide the necessary funds to live your life for as long as it keeps flowing.
For most investments, you’ll need some money to buy in. To buy more stock, you need cash. To get a loan to purchase a business or real estate, you’ll need cash for a down payment.
With high net worth, you have to sell off assets in order to create the cash necessary, and with cash flow, you have to save a portion of your money.
I think there are arguments for both net worth and cash flow in terms of creating the cash necessary to invest. However, getting a loan to invest is a different story.
Getting a loan requires cash flow
When it comes to giving out loans, banks and other lenders look at one metric above all others: Debt to income ratio.
The lender wants to know that you can make the payments on the loan, so they will verify that you have positive cash flow. And they will compare that against the debt payments you currently have.
With a high net worth, but zero cash flow, you would have a very difficult time finding a lender. You would probably end up having to sell off some of your assets to buy the investment outright.
With a high cash flow, you should have no issue whatsoever getting a loan, as long as you have money saved for a suitable down payment.
The ability to leverage your money gives a significant investing advantage to the individual with cash flow. Leveraging your money can increase your returns significantly.
Valuing Cash Flow As Net Worth
Investors purchase cash flowing assets all the time. In fact, the cash flow is often the primary metric in determining the value of those assets.
Usually a cash flowing asset is valued at around 2 1/2 to 5 times the annual cash flow. So if you had a special bank account that magically got $10,000 deposited to it every single month, you could sell that asset to an investor for somewhere between $300,000 ($120,000 x 2.5) and $600,000 ($120,000 x 5).
This means that the cash flowing asset has less short term value than the $1.2 million retirement fund.
So if we put an actual value on it, then the $1.2 million retirement fund would be worth more than the magical cash flowing bank account.
That’s a pretty strong argument to take the retirement account if given a choice between the two.
Why I’d take the $1.2 million
I would take the $1.2 million, but here’s what I’d do with it. I’d sell it all and purchase a cash flowing asset.
Instead of taking the easy $10,000 per month, I could take the $1.2 million stock portfolio and sell it all to buy an asset that cash flows at least $240,000 per year or $20,000 per month.
Why I Personally Prioritize Cash Flow
I’m not going to pretend like net worth is useless because it’s absolutely not. High net worth affords you a lot of opportunities and it also provides more security than cash flow.
I think it’s completely reasonable to prioritize net worth, but that’s not my investment strategy.
And here’s reason #1
Cash flow lets you retire early
Kate and I started investing in real estate about three years ago. In three years, we created approximately $60,000 to $70,000 per year in untaxed income. We did this by purchasing cash flowing investment properties and paying off bad debt.
Kate was a full time occupational therapist and made about $60,000 per year. As we bought up investment properties, she was able to start working part time and this year she quit her job to manage our Airbnb properties and be a stay at home mom.
We are hoping to replace my income through cash flowing investments over the next three years, allowing me to retire at the age of 35 or 36.
Retirement funds can’t do that. Stocks can ‘t really do that. Unless you’re willing to FIRE and live off something like 25-30% of your current income, you’ll need to invest for cash flow.
In order to survive without a job, you NEED cash flowing investments.
You must sell assets to cash in on net worth
This is another big reason why I don’t invest for net worth. If I have cash flowing assets, then I can become wealthy without ever having to sell any of them.
I just don’t like the idea of selling anything that makes me richer.
Stocks without dividends make me richer, but I can’t realize that wealth without selling the stock.
Stocks with dividends make me richer, and I can cash in on that wealth through the dividends without having to sell. I prefer to never sell something that makes me richer.
Same with real estate. It’s always appreciating in value, so I’d prefer not to sell it if possible.
Now this isn’t a black and white rule. I can sell real estate and defer all taxes by exchanging that real estate with another investment property. I’m more than happy to exchange one asset for another.
But I’m not interested in exchanging an asset for cash. Cash is a liability. Holding cash makes me poorer because of the force of inflation. Cash loses value over time.
I use leverage to increase ROI
Like I mentioned earlier in the article, lenders typically want to see a certain ratio of debt to income in order to lend you money. That means you need cash flow to create the income.
Not every investor uses leverage. And if that’s you, then leverage won’t be a compelling reason for you to invest for cash flow.
But here’s the thing.
I know that leveraging my money by getting a loan to buy a cash flowing asset I can’t afford can take my ROI from 20% to 30% in real estate. In fact, it can increase your returns in any form of investing if you’re wise about how you use your debt.
So I need cash flow to get loans, and I need loans to increase my ROI, and I need increased ROI to reach retirement and financial freedom faster. So I invest for cash flow.
Cash flowing investments have higher ROI
If I could make 30% return on investment from buying index funds, I’d be buying index funds. But I can’t do that. The best I can hope for over long periods of time is probably 12-15%, and it’s more likely that I’ll end up seeing 8-10% returns.
But real estate and business are the investments that have the highest expected return potential of all the investment types. And real estate and business are primarily cash flowing investments.
So for the simple reason that cash flowing investments make me rich faster, I’m preferring them over net worth type investments like the stock market.
Lots of investors measure their success by looking at net worth. I measure my success by looking at cash flow.
I do this because my cash flow will lead me into early retirement, it allows me to hold the assets that make me richer forever, and it allows me to leverage my money to increase my ROI.
I think the choice to prioritize net worth or cash flow should be made on a case by case basis. It’s something that should be dependent on your investment goals.
But I would argue that, if your primary goal is to retire as early as possible, you should probably be weighing your cash flow more heavily.