Do You Know the Difference Between Cash Flow and Profit?

 

downloadWHY MILLIONAIRES GO BANKRUPT

“That is exactly why we cannot loan you the money you need,” I said in response to a potential client explaining to me that he has over $20,000 a month going through his account.

Cash is king. If you have it, you stay in business. If you don’t… you don’t. A lot of money going through your account does not matter. In fact, that is not a good thing unless the money into the account is more than the money out. In this case, this particular client was doing very well financially on paper. He had a high net worth and several assets. The problem is, he set up the loans on his rentals to pay them off early and was spending all of his rent, and sometimes more than his rent, to make the payments. These rentals were profitable because income was more than the expenses, but he had no cash flow. The principal portion of your payment each month is a reduction of debt, so it is not an expense. In the long run this will prove beneficial, but it is risky. In this case, he was using shorter term amortizations to reduce his loan size quickly. All of his loans were set up as 15 year loans. Although, with the exception of a default, this is a sure fire way to speed up the loan payoff, I believe there are better ways to do it.

I made a similar mistake when I was really young. Whenever I got some cash in the bank I would want to invest it right away. After all, money in the bank is not working for me. I could earn much higher returns in other investments. I was buying houses at a rapid pace, and quickly became a millionaire. I was extremely proud that I hit that status long before my 30th birthday. The lesson I learned the hard way is that your net worth really doesn’t mean much. Net worth is simply your assets minus your liabilities. All my assets were in real estate. It was easy to buy discounted properties, so I increased my net worth each time I purchased a home. I am sure you have heard the term, “you make money when you buy.” That could not be truer. Although you make money when you buy, you can’t spend it until you sell. My model was almost exclusively buy and hold, so I never really generated the cash reserves I needed to withstand a problem. And a problem is exactly what I got. I was a millionaire and could not pay my bills.

I am a big leverage guy. I believe strongly that you need leverage to reach your potential. You will make more money and grow faster with leverage. Although I think you need to leverage people as much as money, I am going to focus on money for this point. If you have a lot of leverage in the way of loans, you need to make money to pay it off. Companies, and frankly our Government, end up spending all of its revenue to pay off debt; and although they are profitable, they are broke.

Once I shifted my focus to cash flow I was able to rebuild a much stronger financial picture. I rebuilt much more slowly and smarter. I still love and use leverage, but I am smart about it and stay diversified. I have access to cash if I run into a problem, and I use my assets to steadily pay off debt AND produce cash each and every month.

I prefer cash over equity in a home, but I am not necessarily saying don’t focus on paying off your mortgages. For many people that is an extremely positive thing.