Saturday, October 24, 2015

The importance of one's net cash flow

This article is intended for those new to investing and for those who want to learn how to better control their finances. This post will talk about one's net cash flow, what it is, and how wealth is related to it.

In order to create wealth, an investor needs to have extra cash to invest. Normally, cash can only be obtained by one's main vocation, existing income generating vehicles, inheritance, or charitable donations from others. When a person is starting from ground zero, the regular job will likely be the primary source of cash.

Below is an illustration I drew to show what my plan is to generate wealth. It provides a simplified view to the "machine" that I plan to build. The machine described here is a cash generating vehicle. One can think of it like a money printing machine. Over time this machine will invest back on itself and upgrade its money printing capabilities.

Having a high income does not make one wealthy. It took me some time to realize this but having a well paying job does not mean one can afford everything that comes with "looking apart". The cost of living is extremely important in determining one's net cash flow. If one has a very high income and a very high way of life, then he is just living high. But if one is wealthy and living a high way of life, then he is doing so because he has to means to do so indefinitely.

This is not rocket science:
Net cash flow = (Cash from work + Cash from income generating assets) - (Debts and Liabilities)

Cash from income generating assets can be in many forms. This website talks mainly about dividend generating equities. But cash sources can be generated from things like rental income or patents or being the owner of a business.

Living high without a substantial asset base is akin to living on the edge. Were one to lose employment, the cost of living will make one's net cash flow highly negative. If one has substantial car loans and housing mortgages to pay then the net cash flow will either eat away one's existing wealth pool or cause one to go into bankruptcy. It is highly advised that all sources of negative debt with high interest be flushed as soon as possible before building one's asset pool. The negative interest is effectively a negative snowball that severely hampers one's ability to build up wealth.

I don't feel that it is necessary to live extremely cheap and starve oneself from enjoying life. As long as one has the positive net cash flow to do so then it is not a big issue to enjoy life. I am not a firm believer of extreme frugality but I also do not agree with buying in excess. I like to find areas where I can reduce my cost of living since reducing the negative cash flow elements will help speed up the positive wealth accumulation snowball. Every dollar put into assets will help generate even more cash which can be fed back to buy even more assets. By increasing the size of one's income generating assets, the positive cash flow from dividends increases over time. This creates a positive feedback loop that can grow exponentially. On the contrary, if one has a lot of liabilities (negative cash flow), one will be continuously pulled down into the ground. All positive cash flow sources will have to fund the negative cash flow sinks. This will hamper the positive feedback that helps generate wealth.

Eventually, over time, the size of the income generating assets becomes so large that one no longer needs to work at his primary vocation in order to support the negative cash flow. For example, if one's dividend income stream is high enough to pay for one's food, housing, utilities, and transportation costs then one will not have to rely on a main job to pay for those expenses. If one's passive income is large enough to have money left over (even after paying for cost of living and liabilities), that is a very good position to be in since there will be money left over to grow the pool of income generating assets.

My ultimate goal in the future is to have enough passive income to pay for a future mortgage, my food, utilities, and transportation costs. Once this goal is achieved, I will no longer have to worry about layoffs or unexpected events in life.

2 comments:

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  2. Great post young dividend, we are in the way to FI, and as i always say - keep the snowball rolling

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