Cash Flow vs Net Worth | Diving To Understand Which Number Is Essential!

In this blog, we are going to discuss the two essential financial terms - Cash Flow and Net Worth. Both these terms have huge weightage in understanding the financial status of an individual. 

Several digits are summed up to understand the financial status of an individual. These include the money/value of assets a person owns and the money that he/she makes. 

But not all digits should be relied on to measure a person’s financial freedom. 

For instance, a person works towards good health that helps him/her to determine what level that person can be engaged at but still depends on oxygen to survive. Without sufficient oxygen, he/she can not survive, no matter how healthy he/she is. So, what holds more power, the level at which he/she can engage or the ability to engage? Similarly, in the financial sphere, net worth provides a snapshot of your financial health but like oxygen, the future can only be predicted by your cash flows.

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Wealth is just a pile of assets. Cash is real.

Your net worth or wealth is not what you own (assets) but what you are left with after subtracting what you owe (debts). 

For instance, Gautam Adani has a net worth of about $118.6 billion after deducting all his debts and liabilities from the gross wealth he owns. These billion-dollar numbers show the strong financial state of Adani but they are not going to fulfill all of his cash requirements by themselves. If he sells a part of his assets every time he needs cash, he will run out of liquid assets and may eventually end up being broke in the future. 

There’s another prominent example that one can look at to understand this difference better. 

Anil Ambani, once the world’s sixth-richest billionaire with assets worth $42 billion, declared himself bankrupt to Chinese banks in 2020. He also informed a UK court that his net worth was zero. This was largely attributed to his loss-making entities and accumulation of huge debts. Net worth, not being liquid, can create an ‘all-or-nothing’ situation but on the contrary, cash stabilizes it. 

In this case, a person with a low net worth and higher cash flow is in a more secure situation. A person in this scenario can pay his living expenses and spend on luxuries and investments or savings without getting debt-trapped. Further, that person can always work on passive investing and pursue opportunities that build wealth once his cash flow is stable. Similarly, businesses that have high cash flow are stronger and attract more investors than those that only have high net worth.

Net worth fluctuates with the market. Cash flow does not.

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The value of your wealth is not the same as it was yesterday and will not be the same tomorrow as it is today. 

The change in your net worth is constantly driven by the change in the financial markets or the economy. 

For instance, three years ago you bought a house at Rs. 50 lakhs which is now worth Rs. 75 lakhs according to the current market situation. This resulted in an increase in your net worth by Rs. 25 lakh but it did not increase your immediate ability to spend or save more. In case, the value drops as quickly as it rose, you gain nothing and it doesn't impact your income in any way. 

On the contrary, cash flow is tangible and more reliable than net worth. The money you make periodically is the value that holds the purchasing power more than the value that is tied up in your assets. Cash flow fluctuates with the market as well but you have more control over it and can be adapted concerning the demand. Once you create income streams, it remains steady and you can take in enough income to offset occasional dips as well.

All flash & no cash invite bankruptcy

Supposedly, a corporate lawyer belonging to a middle-income group lives in an expensive house, owns luxurious cars, and takes vacations at expensive destinations using credit cards. Whereas an average physician earning the same amount of income practices passive investing creates multiple streams of income & lives a rather simple life. Who do you think is more rich? The one with the higher net worth or the one with the positive cash flow?

In this case, the corporate lawyer has a higher net worth but due to spending most of his income, he may go bankrupt at a certain point. On the other hand, the physician with a lower net worth was more focused on ensuring there is a sufficient flow of cash to meet all his financial obligations without falling into debt. Hence, positive net worth accompanied by higher expenditure & weak cash flow is a threat to your financial future. While, you go a long way if your cash flow is higher than your expenses. 

A gateway to more freedom and opportunities

A positive cash flow gives you the freedom to quit your day job and still lead a financially stable life. Dividends, passive income, or the proceeds of the asset sales combine and establish an income that could be used in building wealth itself.

Not only does cash flow allow you to build more wealth by making more investments but also the freedom to enjoy the returns. High net worth being locked away narrows your scope to grow, evolve, and enjoy, whereas high cash flow allows you to meet your expenses, travel, enjoy life, and work towards your financial goals without worrying.

Create wealth that creates wealth

Large net worth does make you feel confident about your finances but just like market crashes and stocks lose a tremendous amount of their value overnight, it is dangerous to be overly confident about your estimated net worth figure.

The biggest benefit of a large net worth is having more options to create more passive income if you want. The trick is to invest more in assets that produce strong cash flow rather than investing in dead capital that generates no income. While you keep yourself busy in the process of cash creation, your wealth expands and multiplies itself.

One way to do this is by diversifying your portfolio and breaking down your funds into income-generating assets. Alongside, make sure your cash inflows are greater than your cash outflows. This will require you to cut out on your expenses and earn more than you spend.

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Final Thoughts

If you want to be wealthy as long as you live, you need to make sure your cash flow is positive. If you have positive cash flow, you add to your net worth. And, if you follow this habit consistently, then you will never have less money than you have right now. Net worth lets you be content, stay in place, and look wealthy in the present times but cash flow lets you expand, experience, and be wealthier tomorrow.