I went through 12 years of primary and secondary school, four years of college, and three years of law school, and somehow managed to completely miss a basic concept of personal and business finance. Maybe I would have learned this concept if I’d majored in economics, but I get the feeling that most of the equally educated people I meet don’t understand it either. And it’s this one simple concept that completely changed my world view and set me on a different financial course. It’s all about cash flow. And by cash flow, I don’t mean simple account balancing—e.g., money comes in, money goes out, and hopefully the former is equal to or greater than the latter.
Rather, cash flow is about understanding where to put your money when it comes in (assets!) and where to try very hard to avoid putting your money (liabilities!). Assets and liabilities. Let’s define what an asset is. Before I started becoming financially literate, the word “asset” had vague CIA-film connotation of something valuable and hidden, and potentially incredibly lethal. But in finance, an asset simply is something you buy that generates more money for you. Common types of assets are equity (stocks), debt you own (bonds), and real estate you rent to others. Assets by and large generate passive or mostly passive income for you—i.e., the mere fact of owning it entitles you to more money.
In contrast, liabilities are anything you buy that costs you more money even after you buy it. If you’ve bought anything with a credit card, financed a car (or own a car at all), or have a mortgage on your home, these are liabilities. You have to keep paying money to own them, even as they depreciate in value. True, some home and car values go up, but you can’t count on it. A TV or a computer purchased on credit will likely depreciate rapidly while you pay interest on the full purchase price.
How Your Money Flows Into Assets and Liabilities
The flow of money into and out of your possession is commonly known as cash flow. For most people, they get paid and they spend all their money on liabilities and/or stuff. They pay their car payment, their mortgage,* their credit card bill, their student loans, and then they use the rest to pay for eating out at restaurants, buying books, going to movies, video games, etc. They might save a tiny fraction for a rainy day fund. In other words, they enjoy a pretty luxurious life style which scales up with their income almost automatically—either in the form of more liabilities (amazing new car!) or stuff (superior new set of furniture!). Cash flow looks like this:
And that is why most people will never, ever be rich. Not only will they never be rich, their whole lifestyle is on the brink of disaster because any precipitous drop in income means a complete upheaval when servicing the same amount of debt or buying the same amount of stuff no longer becomes possible. This can lead to depression when it happens, and intense anxiety of it happening generally. I speak from personal experience when I say that the anxiety can be especially intense when others depend on you for support.
For people like you and me, who would like someday to be rich (or at least financially independent), we need to enact a different cash flow. When money comes in, it needs to start going into the asset category at a steadily increasing rate. Once we start buying assets, which as noted above produce income for us, our income increases and we can then buy even more assets. The process builds on itself. Thus, in this phase our cash flow will look like this:
That’s a much better picture. That looks like we might actually become financially independent one day. How could we go about increasing the flow of money into assets? Once we’ve achieved debt freedom, one of the best ways to increase the flow without changing our lifestyle at all is to devote all raises and windfall income to purchasing assets. That can rapidly increase an asset purchasing rate from 1–2% of income to 15–20% in a few short years. Additionally, the more we can trim unavoidable liabilities (like taxes), and the less stuff we buy, the faster we can increase the purchase of assets. Doing so creates a positive feedback loop. The more assets we have, the more income those assets create, which makes it easier to purchase still more assets. More assets, more income.
But let’s be honest. It’s all well and good to have a steady (perhaps huge) flow of money into assets which gives us more and more income, but until those assets are generating enough income, we are still required to work. The real goal—for just about everyone—should be to make the income from assets equal to or greater than money spent on unavoidable liabilities and expenses. Once that happens, we’ve achieved financial independence. Our cash flow will now look like this:
Once we hit that point, we no longer need a job. Many still would choose to keep their jobs—they offer social opportunities, prestige, power, etc. But we are not required to keep it. We can demand that the job remain consistent with our moral and ethical compass or we can leave. We are free to give our honest advice. Because we don’t need the work for money directly, it becomes much more difficult to challenge our integrity. If we’re doing a job—or any kind of work—when we’re financially independent, the focus is on the work, its quality, and the meaning behind it. Our ultimate motivation becomes intrinsic (meaning-oriented) versus extrinsic (money/survival-oriented). It sounds like a beautiful place to be. I want to be there. And I hope you do, too.