In today’s world, net worth is often thought of as the most important metric to measure your financial health.
We have the billionaire’s index…which measures the net worth of billionaires. Many personal finance bloggers also track their net worth.
In my view, cash flow is actually more important than net worth.
In a perfect world, you would have both. But for people trying to reach early retirement, I would highly encourage that you focus on cash flow instead of net worth.
Net worth vs. Cash flow: What’s the difference
Before we go further, let’s discuss what the difference is between net worth and cash flow.
Net worth = Assets – Debt
Cash flow = Cash income – expenses
Net worth simply aggregates all of your assets (i.e. home, car, investment accounts, cash) and subtracts out all debt (i.e. auto loan, home mortgage, credit card debt).
In contrast, cash flow measures the difference between your income and expenses.
The high net worth, low cash flow family
I think a big issue today is the high net worth, low cash flow family. As Sam from Financial Samurai has written about very recently, few families have any cash or investments outside their primary home.
I have a friend whose sister and husband fall into this category. Both have great jobs. One is a doctor working at a prestigious university program and the other is a mid-level executive at a fortune 500 company.
They live in a nice part of town where houses regularly sell for seven figures. And they send their kids to a very nice private school.
The only problem? The family is literally living paycheck to paycheck. I estimate they easily make $250,000+ a year. That sounds pretty crazy right?
Well, most of their net worth is tied up in their home.
That’s a big problem. It’s hard to retire early (or at all) when you have no cash flow or even investments outside your home.
I’m weird in that I think of a home as an expense (and not an asset). If my home gains $10,000 in value over the next month what actually happened?
It was just a “paper gain.” I can’t go and spend that money to try a new restaurant or go on a fancy vacation. Having a high net worth is really pointless if you don’t have cash flow to back it up.
Don’t fall for the high net worth, low cash flow family trap!
Here are 3 big reasons why net worth is overrated and cash flow is more important.
1. Net worth doesn’t pay the bills
Net worth doesn’t pay the bills or fund your lifestyle.
The grocery store doesn’t care if you’re worth $2 million. The airline doesn’t care if your home is worth $1 million. All they want is cash.
Net worth doesn’t pay the bills, but passive income cash flow does. If you don’t have enough cash flow you’ll soon need to sell some of that net worth to get by!
And that’s not always easy. Sometimes your net worth is very illiquid.
2. Net worth is just an estimate
One of the biggest gripes I have about net worth is it is just an estimate. Your net worth changes on a daily basis. Stock prices move every second.
The value of your home changes frequently. And the value of your car depreciates more and more every single time it’s used.
In contrast, cash flow is just cash flow. Cash flow is real. It’s tangible…you can hold it.
There’s no estimate of cash flow; either it comes in or it doesn’t.
3. Cash flow is liquid, net worth isn’t
Another concern I have about net worth is that it is often not liquid. Most families net worth are tied up in their home.
Having illiquid net worth is not very desirable in my view. What are you doing to do? Sell a piece of your home to pay for a vacation?
Another big issue is investment accounts…namely the 401(K). When I first graduated from college, I was a big believer in the 401(K).
Defer your taxes, invest the gains, and then take that money out when your tax rate is lower at retirement? Sign me up!
Well, now that I’m a bit older, I realize it was probably a mistake to max out my 401(K) for years.
First, that money is “trapped” in there. I can’t take it out until I’m in my 50’s without incurring significant penalties! I’m a barely into my mid 20s. I can’t imagine having to wait 20+ more years just to touch that money again.
Second, when you net worth is trapped in illiquid assets, it’s hard to re-invest it into passive income streams. When you put money in an illiquid investment account like a 401K, most of the investment allocation opportunities suck.
Most companies have generic index funds. However, if you want to retire early, cash flow is so much more important. It’s unlikely you’ll even be able to invest in dividend stocks with that 401K money!
4. Net worth takes a hit in a recession
A lot of people were hit hard during the recession. This is because most of their net worth was tied to their home or stocks.
That’s the downside of net worth…it can take a hit during hard times like a recession.
In contrast, good passive income cash flow streams keep coming in. Sure, the cash flow stream might dip a little bit, but it’s not the same as having your mortgage wipe out your entire net worth!
Readers, are you maximizing your net worth or cash flow (or maybe both!)? What are your thoughts on illiquid assets like your home or 401K? Let me know in the comments!