When trying to decide how to grow your wealth, it can always be tricky when figuring out whether you’ll get more money from cash flow or capital growth. While both are long-term investments, there are benefits to each.
In this blog, we look at cash flow vs capital growth and which one is best for your situation. We also look at growth rates and a forecast for each, with advice from Inovayt Broker and Business Developer, Martin Vidakovic. Martin strongly believes that cash flow and capital growth go hand in hand when it comes to creating wealth and discusses with us below the benefits of both and how you can use them to your advantage.
What is positive and negative cash flow?
The Corporate Finance Institution defines cash flow as the increase or decrease in the amount of money a business, institution, or individual has. Different types of cash flow include income from your salary, investment property, share dividends and business income for those that are self-employed or have a side hustle. In terms of a cash flow positive property, Martin defines this as “a property that actually makes you money.”
For example – if you purchase a $600,000 property and you borrow $500,000 at a rate of 3 per cent, you’ll be paying $15,000 a year in interest. If the property you purchased is bringing in $600 a week in rent, this will add up to $31,200 a year. Martin says once you conservatively deduct 20 per cent ($6,240) for agents’ costs and other holding costs such as insurances, rates, maintenance, etc, you will still maintain an income of $24,960 which is then yours. Once you pay the loan interest, you will have made about $9,960 cashflow on that property, making it a cash flow positive property.
Something that people often don’t take into account though is negative gearing, which is essentially a cash flow negative property. This is where investors are looking for growth in the asset but are holding onto the property and making a loss because the asset doesn’t produce enough income to cover the costs associated with it. This would happen if the rental income wasn’t high enough to cover the cost of loan repayments, maintenance, interest, or asset depreciation. Most investors who are holding onto a property that is losing money are expecting to make gains from short-term tax benefits. When they eventually sell the property at a higher price, they can make up for the initial loss they experienced.
What is capital growth?
Off the back of our property cash flow discussion, Martin spoke about capital growth being, “the value of the asset – in this example, property – that goes up over time, which, depending on the region, compounds year on year by 6-7 per cent.” Capital growth, however, isn’t necessarily limited to property. There are other options for capital growth including investing in the stock market, starting up your own business which has the potential for growth over time and purchasing an investment like a block of units.
Your Investment Property Mag uses the below example when discussing investing in a cash flow vs a capital growth investment:
“If you invest $400,000 in a cash flow property portfolio and assume that it doubles every 15 years, your initial investment should double twice in value in 30 years up to $1.6m. While this may seem a lot in today’s money, it won’t buy much in 30 years. If, on the other hand, you invest $400,000 in a growing property portfolio and assume it doubles every seven to 10 years, your initial investment should double three to four times in 30 years. If it doubles every 10 years, it’ll reach $3.2m. If it doubles every seven years, it’ll hit around $6.4m.”
What is the cash flow quadrant and forecast?
When talking about cash flow, something you may or may not have heard of is the cash flow quadrant. The cash flow quadrant simply categorises people based on where their money comes from. Martin explains the cash flow quadrant where the following applies:
E = Employee; where most workers sit. It refers to anyone who works for a company that provides them with a paycheck and/or benefits – essentially trading their time and skill for money.
S = Self-employed where this person is their own boss. In other words, anyone self-employed who works for themselves. Similar to the employee category, when they stop working, they stop earning money.
B = Business owner – not to be confused with self-employed! While a business owner does work, they are leaders who own a system where they delegate work instead of taking it on. A business owner could step away from the business for a year or so and have the business still profitable when they come back.
I = Investor, which is where this person owns assets that make money for them, including properties and company shares.
It is possible to be in multiple quadrants and people often are. For example, someone who owns a business (B) could also work within the business (S) for an income. This tool helps you to ascertain where you are making your money from and what the next steps are for you if you are wanting to change quadrants.
A cash flow forecast is slightly different from a budget. Martin explains that while budgets are based on figures that we have right now, a forecast is based on a projection. It is what businesses (although it can be done individually) do when they sit down and project what their income and expenses will be over the next – typically – 12 months. This allows them to discuss their financial goals as well as see whether they are hitting targets to meet these goals as the forecast is generally broken down month to month so success can be managed.
When it comes down to it, there are arguments in favour of both capital growth and cash flow when creating wealth. When looking at all of the above points, the combination of both of these things go hand in hand when you are looking to create wealth.
If you need help with anything discussed in this blog, reach out to one of our team who will be able to assist.