We’ve talked about how cash flow over time leads to building wealth, which is also called net worth.
Today I’ll add a bit to past discussions by showing how these two work together in various scenarios, and what the wealth impact is in each case.
Two Factors
I’ve noted previously that there are two factors that account for whether you accumulate wealth or not: income and spending. This is because income less spending (expenses) generates your surplus. And surplus after surplus over time grows your net worth. If you have no surplus, you have no wealth.
The relationship of these two factors will greatly determine how well you do financially and whether or not you build wealth over time. I thought I would detail the most common relationship options between them and give you my thoughts on each.
Four Common Relationships
There are many different relationships between income and spending (almost an infinite number), but there are four “extremes” that highlight the boundaries of good and bad money management when it comes to these two. Let’s look at these boundaries and take away learnings that can be helpful as we work towards growing our net worths.
For the purpose of this effort, let’s assume that income and spending can only be either “high” or “low”. Doing so leaves us with the following outcomes:
- Income: High
- Spending: High
People with high incomes and high spending are living the “good” life. They are making a lot and spending a lot, likely in an effort to keep up with the Joneses. They live in big houses, drive nice, new cars, take expensive vacations, and on and on. But one thing they aren’t doing is building wealth.
Yes, they have a lot of potential to grow their net worths because they have high incomes. But they spend it all (and in many cases more than what they make) on lavish lifestyles. Hence they have no surplus and thus are not growing their wealth.
- Income: Low
- Spending: Low
These people are in the same category as the ones above but for a different reason: they don’t make much money. As a result, they have to spend all they make on the basics — food, clothing, and shelter. Not much, if anything, is left over. So they have no surplus and thus can’t grow their net worths.
These first two groups are both living paycheck to paycheck, though for different reasons. According to the book The Difference: How Anyone Can Prosper in Even The Toughest Times
- Income: Low
- Spending: High
The worst of all possible scenarios. These people make less than they spend. Every month they go further in debt. If they do it long enough, they are almost certainly headed for bankruptcy. The Difference says that this is the financial situation 15% of Americans find themselves in.
The amounts don’t really matter. They could be making $75,000 a year and spending $100k a year or making $30,000 a year and spending $50,000 a year. Whatever the numbers, the fact is they are LOSING wealth every month because (in most cases) they simply can’t control their spending.
- Income: High
- Spending: Low
The best of all possible scenarios. These people are adding to their net worths in a big, big way. Their surplus is large because they make a good income and keep their expenses under control. They add to their net worths year after year and watch their wealth grow and grow. This is the situation my finances have been in for a couple decades now and the same I want you to achieve if you’re not already here.
Only Two Choices
No matter where you find yourself in the scenarios above, there are only two things you need to do to improve your financial situation and grow your wealth:
- Increase income
- Lower spending
It’s good to do either of these two. It’s better to do both.
Doing one of these will grow your surplus and thus your net worth. Doing them both will help your net worth to EXPLODE!!!
photo credit: Lewis chess glares via photopin (license)
Yep, that’s pretty much what DH and I did to get to where we are today – lived on slightly more than half of what he made. If you have debt you need to be okay with using the surplus to get it paid all off before you start blding a nest egg. Even if you have extra at the end of every month, if you still have debt, you’re not wealthy.
I fully disagree with your last point – you can be very wealthy while holding lots of debt. That’s why ESI refers to wealth as “net worth” – it’s assets minus liabilities. Don’t think for one second that Bill Gates doesn’t have debt. The key is to use debt responsibly (I.e., as a tool for building wealth or maintaining liquidity) and not over-extend.
I also use debt to increase both my cash flow as well as my net worth. In a sense i’m like the old fashioned bank where i sometimes borrow (increase debt) and then turn around and lend it out at a higher rate. Its a productive, profitable use of debt where i can use another’s funds to generate an income by borrowing or taking on debt. Banks used to use that business model whereas now they seem eager to get rid of the loans/mortgages and merely makes profits on the transaction fees or points. They no longer really hold the originated loan in their portfolio till they mature and make money on the interest rate spread.
I have long felt there are 2 ways of getting a pay raise but i said it a bit differently:
1) the normal standard annual standard pay raise,
2) decrease your expenses
I have long felt the easier to accomplish was decreasing your wasteful spending. Over a long period of time its amazing how much you can “save/invest”. Since i didn’t manage my career well i depending more upon living beneath my means (W-2 income) and investments (which i still do despite being in retirement).
Another mentor i followed as offered a contrast to concentrating on cash flow vs increase in capital. In short he said more emphasis s/b on increasing your capital (investment funds) earlier in your career and then more emphasis s/b on cash flow (difference between you income vs what you spend) later in life as you move closer to retirement. You don’t really need the cash flow when you’re younger and more capital invested w/ usually yield a larger cash flow when you need it more when you retire. Real Estate investing i have found is a very good verhicle for this asset class.
As usual, much wisdom being offered by ESI and like Dave Ramsy those who change some of their behaviors will benefit so much in their retirements.
Appreciate the comments! Good stuff!!!
ESI, do you know much about buying discounted notes. That’s an asset class i’m investigating to expand into. Right now most of my lending is in to real estate investors and lines of credit for small businesses. They get so flustered with the way banks treat them and how long loans can take and often the disrespect they feel.
I do not. Sorry.
You have framed these concepts in such a simple manner, and I keep coming back to it constantly as a reminder that none of this is rocket science. Unfortunately, we, as individuals, make things far more complex than they need to be.
It’s reminds me of one of the things I say to my coaches: “football is a simple game, but we over complicate things for our players because we want to sound smarter than the next guy. Running and hitting. That’s all it is.”
Increase income AND lower spending.
Ha! This is a perfect comment for what I just posted this morning:
https://esimoney.com/become-wealthy-described-one-sentence/