When it comes to personal finances, a small business, or a large company, cash flow is generally more important than net worth. If you doubt this, try applying for a loan at a bank. Unless it is an entirely asset-based loan, the bank will only be mildly interested in your net worth, but virtually obsessed with your cash flow.
The reason for this is simple — when you have a loan, repayment comes out of your cash flow, not your net worth.
This is true with finance in general. After all, you don’t pay your basic living expenses out of your net worth, if you did, it would just be a matter of time before you would be completely broke.
No, you pay your ongoing expenses out of your cash flow. And you save and invest money out of your cash flow. This is why cash flow is more important than net worth.
Net Worth is the Past, Cash Flow is the Future
As impressive as net worth might be, it says more about the past than it does about the future. Net worth represents the culmination of past cash flows. It only describes your financial condition up until a certain point in time.
It has little predictive power, which is a major reason banks tend to ignore it when considering whether or not to approve a loan. And again, this is as true for an individual as it is for a large business.
Cash flow is far more predictive of the future. Since it can be measured against cash flow in prior periods, it can indicate the ongoing health of a company in a way net worth can’t.
While it’s true net worth can grow from one period to another, the direction is also more an indication of cash flow than anything else. As cash flow increases, net worth tends to grow as well. If cash flow declines, it takes net worth down with it.
Yes, a company can grow its net worth even without increasing its cash flow, but in order to do this, it must reduce expenses. While it’s always important for a business to keep expenses in check, and operate efficiently, expense reduction does not indicate growth. Only a rising cash flow does.
Investors Don’t Buy Net Worth
Few investors use a company’s book value or net worth as the primary factor in determining whether or not to buy a stock. An investor’s primary area of analysis and concern will be focused on the company’s cash flow. Once again, the reason for this is because cash flow is the best indicator of the company’s future direction. And that’s what investors are looking to buy — a company’s future cash flow.
The most likely scenario in which an investor would focus primarily on the net worth of the company is when it is interested in acquiring the assets of the company.
For example, if an ailing airline company had a fleet of jets worth $1 billion, but a net worth only $500 million, a competitor might be interested in acquiring the company in order to get control of its jets at a discounted price.
In this case however, the investor — who is actually a competitor — is not interested whatsoever in the company’s cash flow, or even its profits. They’re just buying the assets to use in their own business.
Cash Flow = Options
One of the reasons banks and investors love cash flow is because it creates options. This is the same reason why you should be concerned primarily with cash flow in regard to your personal finances.
A generous cash flow provides a business with the opportunity to:
- Pay dividends to investors
- Pay off debt
- Invest in new plants and equipment
- Aquire a competing business
It would simply be a matter of directing ongoing cash flow into whatever the objective is. This can even be done without negatively affecting the company’s net worth.
The company could also accomplish all of these objectives by tapping their worth. But this is a zero-sum game. In order to redirect money into any of these activities, the company would have to reduce its net worth and weaken its financial position in the process.
The same is also true with personal finances, with one such area being retirement planning. Though the goal in preparing for retirement is to create and build the largest retirement portfolio possible, the ultimate objective in retirement will be to live on the income generated by the portfolio.
This will ensure the portfolio remains intact, and able to provide for your retirement for the rest of your life. Even in retirement then, the goal will be to live out of your cash flow, not your net worth.
Use Net Worth to Generate Cash Flow
Whether it is a company managing its assets, or an individual managing her retirement portfolio, the basic purpose of net worth is to generate cash flow. This enables net worth to both support the operations of the company or the lifestyle of the individual, as well as to grow net worth itself.
One of the critical areas stock analysts look at is how well a company manages its net worth. There are various ways this can be done. One method is by determining return on equity, which is calculated by dividing net profit by average shareholder equity. Another is by calculating return on assets, which is determined by dividing net income by average assets for the reporting period.
Though it isn't as obvious on an individual level, a person’s success in investing largely hinges on the ability of his assets to generate cash flow. There are two types of assets at the personal level, investments and consumer goods. The difference between the two isn’t always appreciated or even fully understood.
Actual investments are assets which generate a cash flow. This can be in the form of interest, dividends, capital gains, or rents. Tools for business equipment can be included in this category as well, if you use them to generate income. The larger the percentage of your net worth comprised by investments, the faster your assets will grow and the wealthier you will become.
Consumer goods, on the other hand, are assets which generally don’t generate a cash flow. This can include your personal residence, automobiles, furniture, entertainment equipment, recreational equipment, and jewelry and personal effects.
Although they may be important in your life, some of these assets actually cost money, while others decline in value. If these represent too great a share of your net worth, then your net worth won’t be providing adequate cash flow. You may even experience negative net worth growth.
Net worth is important as a scorecard. But whether you’re an individual or a business, cash flow is more vital.