Most CEOs, founders, and entrepreneurs are well aware of the reasons behind their business ventures. They often talk about autonomy and noble causes, such as improving processes and innovating industries. The traditional view of business success is tied to financial freedom, which is often measured by net worth, an arbitrary figure based on the accumulation of assets such as property, automobiles, jewelry, art, and more. However, a more accurate indicator of true wealth and success, as well as financial freedom, is cash flow. So, what sets cash flow apart from net worth?
Networth is an insufficient measurement of wealth:
It is often mistakenly viewed as a badge of honor, but its calculation is quite simple: assets (savings, home equity, investments) minus liabilities (debts). For example, if you own a home worth $200,000 but have a mortgage of $150,000, your net worth would be $50,000. It may seem straightforward, but there are limitations to this approach.
However, there is a common misconception that when someone buys a home, even with a mortgage, the entire value of the home is included in their net worth. Using the same example, one person may correctly calculate their net worth as $50,000, while another person may mistakenly believe their net worth is $200,000, including the total value of the home. This discrepancy arises because net worth does not take into account the outstanding mortgage or other liabilities, which can significantly impact the true financial picture.
The estimated value of a property remains speculative until it is sold. Additionally, the equity or net worth of the property is illiquid, meaning it cannot be readily accessed or converted to cash as easily as funds in a bank account. In essence, net worth is an approximation of wealth based on the most informed estimate of the property’s value.
Why Cash Flow is a Better Wealth Metric:
Unlike net worth, which may be tied up in assets that are not easily liquidated, cash flow is readily available and stable. It also provides valuable insights into future financial prospects. Positive cash flow empowers you to cover expenses, create an emergency fund for unexpected situations, and capitalize on investment opportunities. In the realm of wealth, cash flow reigns supreme as it represents actual streams of income.
So, what steps can you take to boost your cash flow and enhance your overall wealth?
Most CEOs, business owners, and entrepreneurs are familiar with the concept of transitioning from a W-2 income to a K-1 income. A W-2 represents earned wages as an employee, while a K-1 represents profits as a business partner. As entrepreneur Jim Rohn once said, “Wages earn a living. Profits earn a fortune.” The goal is to generate profits.
To achieve a steady stream of profits, it is crucial to diversify your income streams. On average, multimillionaires have at least seven streams of income. Historically, diversification can be achieved in three ways: through earning income, portfolio investments, and passive investments. Earning income is straightforward – you provide labor, sell a service or product, and earn an income or profits. The second method involves traditional savings and investments, such as CDs, index funds, stocks, bonds, or savings.
Passive income, on the other hand, allows your money to work for you while you sleep. This type of income can be generated through traditional methods, but savvy investors are now exploring alternative avenues such as crowdfunding, venture capital, syndications, and real estate investments.
Considerations When Building Cash Flow
The velocity of money, or how quickly it changes hands, is a crucial factor to consider when building cash flow. It is essential to reinvest the money you earn into income-producing opportunities promptly. Diversification is also key – avoid putting all your eggs in one basket. Spreading your investments across multiple streams of income ensures that if one dries up, you have others to fall back on.
Additionally, consider your risk tolerance for different income streams. Some sources of income may be more stable than others. For instance, dividend-paying stocks tend to be more stable compared to stock options. However, you may need to consider taking on slightly more risk for the potential of higher returns.
Lastly, tax planning is crucial when building cash flow. Make sure you are aware of the tax implications of each income stream and structure them in a way that optimizes tax savings.
Five Steps to Increase Your Cash Flow
- Maximize your earned income.
- Create a source of portfolio income through stocks, bonds, and equities.
- Establish a source of passive income, starting with real estate investments.
- Optimize tax efficiency.
- Invest in your financial and investment education.
Consider this article as a source of financial inspiration, for knowledge without action is incomplete. Building a strong financial foundation may require time and effort, but taking action on the ideas outlined above is wisdom in itself. Set a cash flow goal, choose a vehicle, and start taking steps toward financial success today.