Having discussed income ad nauseam, it is time to make a clear distinction about what income does and does not do. Income may or may not cover your expenses, and it may or may not leave anything for you to spend after your bills are paid. What it most certainly does not do is provide anyone with financial freedom.
Financial freedom can result only from passive cash flow in excess of your living expenses.
“If the truth were self-‐‑evident, eloquence would be unnecessary.” -Marcus Trullius Cicero
Confusing Income for Cash Flow
They are not at all the same thing. Let me paint you a picture. Suppose you were hired to cater a dinner for 200 people. You were told that you could eat any leftovers after all of the guests had been served. If all the guests showed up and ate more than their fair share, you’d be out of luck and going home to scrounge peanut butter and jelly sandwiches for dinner. But if less than 200 guests arrived and ate modestly, you’d have enough leftovers to take home for your entire family to enjoy. Sure beats peanut butter!
Now relate this scenario to your income. The food that you prepared as a caterer is the equivalent of the money you earn from your paycheck. As the money comes in, everyone gets served. The guests are the expenses you incur to maintain your standard of living. Some expenses eat a lot of your take home pay, some eat a modest amount. The guest of honor at the party you are hosting is the tax man. He gets the first plate of food, and he eats a lot. Then the bank that holds your mortgage and car loans, the credit card companies, utility companies, gas stations, cable and internet provider and on and on it goes. The leftovers, if you have any, are your cash flow. And that’s what you get to eat.
Earned Income and Cash Flow
Let’s make sure we understand each other. If there is a combined income of $2,600 per month in a household, but the expenses are also $2,600, then the household cash flow is $0. In other words, there’s just enough money to cover the most immediate living expenses but no savings. Thus in the world of earned income, cash flow is the equivalent of savings. To measure the rate of earned cash flow you simply measure the rate of savings. For example, if on gross income of $2,600 our imaginary household manages reduce their expenses and can now save $260 per month, then their rate of cash flow is positive 10%. ($260 / $2,600 = 10%)
On the other hand, if the same household fails to control their expenses and ends up spending $2,800 one month because a car breaks down or their daughter absolutely needs a new set of pompoms, then their cash flow is $2,600 -‐‑ $2,860 = -‐‑ $260, which constitutes a negative rate of cash flow of -‐‑10%. (-‐‑$260 / $2,600 = -‐‑10%) Unfortunately, this is the point at which many of us reach for the credit card…
Do Your Have Sufficient Cash Flow?
At this point I’d like to ask you the following question: Assuming you are now working as hard as you can, do you have enough leftovers to be satisfied? When I asked myself this question I realized that the answer was a resounding “no.” I am a musician, and my earning potential at the time was simply too low. True, there are always ways to improve earned cash flow, but the point I’m trying to make is that I realized that there really wasn’t much I could do within the professional realm of my world to make a significant enough difference in my cash flow. I was going to have to find another way to increase my cash flow if I was ever to afford the kind of life that I wanted.
Earned Income Cash Flow vs Passive Income Cash Flow
Now that we agree on the basic principal behind the term cash flow, let’s further break it down into two types. Beginning with a general formula for cash flow:
Income – Expense = Cash Flow
- A) Earned Cash Flow: Earned Income (from a job) – Expenses= Earned Cash Flow
- B) Passive Cash Flow: Passive Income (from an investment) – Expenses = Passive Cash Flow
The biggest problem with the world of earned cash flow is that it offers very few options for expansion. This is precisely why so many people find themselves going back to school for more education hoping to become more marketable in their profession. Another problem with earned cash flow is that it is extremely time-consuming. There are only twenty four hours in the day and it is extremely difficult to work two or more jobs in hopes of having enough leftovers to feed the family’s wants and needs.
When it comes to passive cash flow it is a different story all together. Because the world of passive income has so many moving parts, there are always many options for me to increase my passive cash flow. For instance, I can buy another property, or I can improve cash flow of one that I already own by increasing rents. I can refinance to lower my mortgage payments, or decide to pay off the mortgage entirely leaving the building free and clear and making bank every single month.
Multiple Streams of Cash Flow from Passive Income
Furthermore, another benefit of passive cash flow is that because it takes more knowledge but less time-commitment, it is possible and even probable to develop multiple streams. If something happens to one, you have others to fall back on while you get yourself sorted out. Not many things in life come with that kind of security.
Isn’t it ironic that income which is classified as passive offers so many options making it seem to me quite active, while earned income that we slave for day in and day out has such rigid and stagnant limitations? Yes, I firmly contend that passive cash flow is at the heart of financial freedom.
If you want the full picture on developing cash flow, see my Cash Flow Freedom University >>