Is Net Worth or Cash Flow Better

Is Net Worth or Cash Flow Better?

The argument is simple – which is more meaningful, which has more impact Net Worth or Cash Flow?

Net Worth Formula

The formula for net worth is:  Assets – Liabilities = Net Worth

Cash Flow Formula

The formula for cash flow is:  Income – Expense = Cash Flow

“Happiness is a positive cash flow.” -Fred Adler

Is Net Worth or Cash Flow Better?

Which is more meaningful; which has more impact?  Much as I believe that cash flow is central to the attainment of financial freedom, I think that net worth is the most meaningless concept in all of financial literacy.  Why?  Because cash flow puts bread on the table, net worth just looks good on paper!

As you know, the vast majority of assets out there do not register any positive impact on the owner’s income statement.  The only way to convert such an asset into spendable cash is to sell it, which can be difficult.

I operate under the principle that cash flow, more specifically passive cash flow, is the oxygen of our financial existence.  I do not need assets to pay for food, medical, and my kid’s college bills.  What I need is cash flow!  Net worth without cash flow is like lungs without air – it’s there, but it’s kind of useless.  Though it looks good on paper, it does not contribute positively to a person’s capacity of achieving financial freedom unless the underlying assets are of the income-producing variety.  I know many people who have high net worth and yet they are paupers, relying on their high-flying jobs to pay the bills every month.  In fact, let me introduce you to a couple of friends of mine named Frank and Debbie.

New Worth vs Cash Flow Case Study: FRANK  and DEBBIE

When Frank graduated from college, he got hired-on by the company that he interned with while in school.  His starting salary was around $40,000, but along the way his company paid for his MBA and Frank was on his way up the corporate ladder.  In 2010 he is earning a salary of about $90,000, plus benefits and a 401k plan.  He deserves every penny. Frank happens to be an extremely level-headed, rational, and un-emotional problem solver.

Frank’s wife Debbie is a very bright and capable woman in her own right.  Having earned a Bachelor degree from a university, it was not long before she was gainfully employed, earning a pay similar to her husband.  Her company helped pay for her MBA also, and currently she earns a comfortable $80,000 per year.  Together, Frank and Debbie earn over $170,000 before taxes, which puts their household solidly within the top 10% of households in America relative to income.

For the first ten years of their marriage (before they had kids) Frank and Debbie lived in a comfortable but affordable (for them) $150,000 home, which was about 1,800 square feet and cost them just over $1,000 per month including property taxes and fire insurance.  They drove newer model mid-size vehicles, took vacations, and spent money on entertainment.  Their lifestyle during this period was comfortable, though they still managed to bank almost $1,500 of cash flow per month.  Incidentally, $1,500 per month of savings constituted a 20% savings to gross income ratio at that time, which is respectable.  This rate of cash-flow had allowed Frank and Debbie to accumulate a sizable Savings Fund of $180,000 over ten years.   Naturally, besides an actual savings account they held most of the money in bank certificate of deposits, money market accounts, stocks and other liquid instruments that earned minimum interest while still providing easy access.  On the next page is their financial statement dating to the beginning of their careers.   This is before they climbed the corporate ladder and got their pay raises.

Income and Loss Statement

INCOME & LOSS STATEMENT Frank and Debbie: 1998
Earned Income Gross Income      
Earned Income 1 Gross ($50,000/yr.)

$4,166.67

Earned Income Total

$7,500.00

Earned Income 2 Gross ($40,000/yr.)

$3,333.33

Passive Income (R/E Income)

$0.00

Passive Income (business, real estate, annuity, etc.)      
Rental Income 1

$0.00

     
Rental Income 2

$0.00

     
Rental Income 3

$0.00

     
Rental Income 4

$0.00

     
    Gross Income

$7,500.00

Expenses        
Personal Expenses        
Credit Card 1 (interest only @ 8%)

($26.67)

Personal Expenses Total

($6,024.49)

Credit Card 2 (interest only @ 9%)

($52.50)

Business Expenses Total

$0.00

Car Payment 1 ($15,000 @ 5%, 60 mo.)

($283.07)

     
Car Payment 2 ($15,000 @ 5%, 60 mo.)

($283.07)

     
Income Taxes

($1,875.00)

     
1st Mortgage (120k, PITI at 6%, 360)

($1,044.19)

     
Utilities

($200.00)

     
Groceries

($500.00)

     
Insurance (Auto)

($60.00)

     
Insurance (Health)

($200.00)

     
Gasoline

($200.00)

     
Cell Phone/TV

($300.00)

     
Repairs and Maintenance

($200.00)

     
Child care N/A      
Vacations

($500.00)

     
Clothing & toiletries

($150.00)

     
Entertainment

($150.00)

     
    Gross Expenses

($6,024.49)

Business Expenses        
Legal & Accounting

$0.00

     
N/A

$0.00

     
N/A

$0.00

Earned Cash Flow

$1,475.51

N/A

$0.00

Passive Cash Flow

$0.00

N/A

$0.00

     
    NET CASH FLOW

$1,475.51

         
BALANCE SHEET        
Assets

Current Value

Liabilities  

Balance

Savings Fund

$180,000.00

Credit Card 1  

($4,000.00)

Residence

$150,000.00

Credit Card 2  

($7,000.00)

Checking Account

$2,000.00

1st Mortgage Balance

($115,000.00)

Car 1 Value

$12,000.00

Car Loan 1 Balance

($12,000.00)

Car 2 Value

$12,000.00

Car Loan 2 Balance

($12,000.00)

Retirement Account 1

$125,000.00

     
Retirement Account 2

$80,000.00

     
         
         
         
TOTAL ASSETS

$561,000.00

TOTAL LIABILITIES

($150,000.00)

         
NET WORTH      

$411,000.00

As you can see, Frank and Debbie’s gross income of $90,000 per year afforded them a rather comfortable life-style in 1998. As a side note, I must point out that Frank and Debbie made wise choices regarding their college degrees.  Frank and Debbie must made wise choices regarding their college degrees; not every college degree out there would have provided for such comfortable beginnings.  They must have put thought into matching their personal strengths with expected salaries, within a field whereby companies not only pay good salaries, but also tend to underwrite the expense of the continuing education.  Most people do not choose as wisely, but that is a topic for another book. 

By 2009, Frank and Debbie’s combined income had grown to $170,000 per year, and following the arrival of their first child, Frank and Debbie upgraded their affordable abode to a gorgeous, custom-built home in an up-scale gated community, for which they paid $600,000.  They utilized $20,000 from the sale of their old house toward the 20% down-payment, and took $100,000 more from their savings.  The rest they financed with a bank mortgage of $480,000.  Prior to moving into the new house Frank used $15,000 more of their savings for a “light” remodel.  Thus, Frank and Debbie used a total of $135,000 of cash savings toward the new house which, incidentally, constituted roughly two thirds of their savings.  Their new home, including taxes and insurance costs them almost $3,300 each and every month.  Now their family of three can finally drop their luggage and get comfy within the 3,000 square feet and four bathrooms…

As you can imagine, Frank and Debbie now both drive luxury imports which they upgrade every few years.  In their defense, sort of, they do make substantial down payments so that the loan payments do not exceed $500 per month/ per car.  They now spend a combined $1,000 per month for their cars.  They enjoy several luxurious vacations every year, for which they continue to budget $500 per month.  They go out to nice restaurants several times per week.  And let’s not forget Frank’s passion for fine cigars.  In short, Frank and Debbie boast many attributes of well to do affluent individuals.  Below is their current financial statement.

Income and Loss Statement

INCOME & LOSS STATEMENT Frank and Debbie: Current
Earned Income Gross Income      
Earned Income 1 Gross ($90,000/yr.)

$7,500.00

Earned Income Total

$14,166.67

Earned Income 2 Gross ($80,000/yr.)

$6,666.67

Passive Income (R/E Income)

$0.00

Passive Income (business, real estate, annuity, etc.)      
Rental Income 1

$0.00

     
Rental Income 2

$0.00

     
Rental Income 3

$0.00

     
Rental Income 4

$0.00

     
    Gross Income

$14,166.67

Expenses        
Personal Expenses        
Credit Card 1 (interest only @ 8%)

($66.67)

Personal Expenses Total

($12,313.64)

Credit Card 2 (interest only @ 9%)

($75.00)

Business Expenses Total

$0.00

Car Payment 1 ($25,000 @ 5%, 60 mo.)

($471.78)

     
Car Payment 2 ($25,000 @ 5%, 60 mo.)

($471.78)

     
Income Taxes

($3,541.67)

     
1st Mortgage (PITI at 5%, 360)

($3,276.74)

     
Utilities

($400.00)

     
Groceries

($1,000.00)

     
Insurance (Auto)

($60.00)

     
Insurance (Health)

($200.00)

     
Gasoline

($300.00)

     
Cell Phone/TV

($300.00)

     
Repairs and Maintenance

($200.00)

     
Child care

($1,000.00)

     
Vacations

($500.00)

     
Clothing & toiletries

($150.00)

     
Entertainment

($300.00)

     
    Gross Expenses

($12,313.64)

Business Expenses        
Legal & Accounting

$0.00

     
N/A

$0.00

     
N/A

$0.00

Earned Cash Flow

$1,853.03

N/A

$0.00

Passive Cash Flow

$0.00

N/A

$0.00

     
    NET CASH FLOW

$1,853.03

         
BALANCE SHEET        
Assets

Current Value

Liabilities  

Balance

Savings Fund

$65,000.00

Credit Card 1  

($10,000.00)

Residence

$600,000.00

Credit Card 2  

($10,000.00)

Checking Account

$2,000.00

1st Mortgage Balance

($480,000.00)

Car 1 Value

$40,000.00

Car Loan 1 Balance

($23,000.00)

Car 2 Value

$48,000.00

Car Loan 2 Balance

($22,000.00)

Retirement Account 1

$280,000.00

     
Retirement Account 2

$250,000.00

     
         
         
         
TOTAL ASSETS

$1,230,500.00

TOTAL LIABILITIES

($545,000.00)

         
NET WORTH      

$685,500.00

This financial statement obviously belongs to an affluent family.  It is definitely tempting to be impressed with the $14,000 of monthly gross income, and a $685,500 net worth.  However, I have some reservations.  For instance, Frank and Debbie’s cash flow of around $1,850 constitutes only 13% of their gross income, which seems much too low considering the magnitude of their income.  In both personal, as well as business finances, I would say that it is desirable to cash flow 25% – 40% of gross revenue.  Otherwise the rate of savings is too slow to make a meaningful impact in times of financial distress.

I heard Steven Rattner, a well known American financier on a CNBC show Morning Joe in November of 2011 addressing the issue of savings rate in this country and the world.  According to Rattner, in the 1970es Americans saved around 10% of their pay.  But by 2005, the savings rate in this country was less than 1%.  Following the financial crisis of September 15th, 2008 the savings rate briefly climbed toward 6%, but by 2011 it started to slip again.  In the mean time, the savings rate in Germany, according to Rattner, is around 10%, while in China it is a whopping 40%.  Could it be that the financial crisis was worse than it had to be because we, as a nation, were overspending to begin with?  We had nothing in the bank when shit hit the fan…

Living Above Your Means

Getting back to Frank and Debbie, at the current rate of savings it would take them close to eight months to accumulate enough savings to cover one month’s worth of their current expenses.  Patrisha and I accomplish this in under two months.  In my opinion, what they are doing is dangerous and completely unacceptable, especially for individuals capable of generating such high income.  Finally, while their cash-flow in this financial statement is up by roughly $400 per month relative to their financial statement from the previous decade, their expenses have doubled.  This is what living above your means looks like!

Earned Income or Passive Income

It is evident in Frank and Debbie’s financial statement that all of their income is earned; there is no passive income.  They have been very active acquiring liabilities – things that cost them money, and have not considered acquiring positive cash-flow assets.  Frank and Debbie are obviously more concerned with living an affluent life rather than a financially free one.  Frank and Debbie score an A+ in affluence and a D- in financial freedom.  If you know any Frank’s or Debbie’s out there, tell them to sign-up for my blog.  They could make a big difference in their lives with just a little knowledge and effort.

The Earned Income Cycle

Earned income is a sword that cuts both ways.  On one side, it will build your dependency on the paycheck, if you let it.  On the other side, it can buy you a ticket out of the rat race if you live frugally and invest as much as possible into acquisition of positive cash-flow assets.

Frank and Debbie do not have any such assets on their balance sheet.   Is this really surprising, though?  After all, they make such high pay that seemingly everything they could possibly desire is attainable to them.  Why should they worry about the management headaches which come with positive cash-flow assets?

The dark side of this is that Frank and Debbie are not about to give-up the affluent life.  And because of this they will gradually become more and more addicted to the paycheck.  And thus the cycle perpetuates…until it ends abruptly because of illness, lay-offs, divorce, etc.  I hope this never happens to Frank and Debbie.  But I do know several people who have not been so fortunate!

2 Comments

  • Serge S. Reply

    This is a well written article Ben. I would add though that not every “asset” is created equally. That investment account that yields little dividends worth $100k does not provide me the benefits of a home I purchased for $100k that is worth $150k and produces $1200 gross rental income. Also – theoretically a persons net worth should dictate the amount of passive income they are generating. As such, it is a VERY valuable metric. EVERY investment decision should be judged on not just the income it produces but effect on our balance sheet (net worth). There will be times in an investors career when adding net worth is more important than adding cash flow.

    Just as all assets are not the same, all income is not the same. You clearly made that point. One thing I would add is that a persons burn rate (monthly living expenses) looks very different depending on the nature of the income. With earned income, I would be worried if I spent anywhere near 30% of my gross W2 income. If my income was passive and seasoned, I am very content spending 50% maybe even 60%. I would love to see an article from you discussing this as I think it would be very useful to your readers.

    • Ben Reply

      Is this the Serge S. whom I know and love by chance…?!

      Serge, I quote you – “theoretically a persons net worth should dictate the amount of passive income they are generating”. This perspective on net worth would indeed qualify it as quite an important number. This is how you look at it. This is how I look at it. This is NOT how then majority of people see it. To most, it is an either or – either cash flow, or net worth, and faced with that choice people are better off going with CF all day long!

      Leveragable equity has a lot of value to you and me. This is rather not what the article is about, however 🙂

      The other point that you bring up is relative to intrinsic value of cash flow differential when comparing earned vs. passive cash flow, and how this intrinsic value drives the DTI ratio. Yes – this would make an interesting article indeed. Would you like to write it; I’ll post it on the blog with full attribution to you?

      Thanks so much for your comment, Serge!

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