Russell is very fond of Robert Kiyosaki’s Cash Flow board game. He and Carol even used it to further their daughter’s financial education. It’s a good learning tool, even if it has a few unrealistic assumptions.
Photo Source: Amazon
Cash flow is one of the most important parts of your business. Many people equate cash flow to profitability, but they are really two different (if related) things. I’ll get to that after I refresh the definitions I’m working with. There are two types of cash flow:
- Positive cash flow
- Your business brings in more money than your expenses, including mortgage payments, including taxes, interest, and insurance
- Negative cash flow
- Your business brings in less money than its expenses
Positive and negative cash flow are closely related to profit and loss. Merriam-Webster’s second sense of “profit” is probably the most instructive of the dictionary definitions:
1 : a valuable return : gain
2 : the excess of returns over expenditure in a transaction or series of transactions; especially : the excess of the selling price of goods over their cost
3 : net income usually for a given period of time
The fifth sense distinguishes between profit and wages or rent. But when I speak of the difference between profit/loss and cash flow, profit/loss can include things, like depreciation, that exist only in the tax code and do not affect your actual bank accounts. Profit/loss on a project should also include expenses that have already been accounted for. This last bit confuses a lot of people. When the money is already spent, it can be disheartening to subtract it from a big pay check you just received.
Depreciation is a way to recover the cost basis of an asset though deducting a portion of its value over time.
Image Source: Zilculator
Depreciation
You can have positive cash flow and still not be profitable. One reason for this is the wonderful part of our tax code known as depreciation. Let’s say your properties bring in a few hundred dollars each month more than their cumulative expenses. You have a business-wide positive cash flow. But at the end of the year, you are still required to depreciate those properties. After all, they are experiencing wear and tear and a steady slide into entropy. The tax code lets you deduct a certain amount of money on each of those properties for depreciation.
That deduction enables you to experience to the magic of positive cash flow and a simultaneous tax loss.
Expenses
I was having a conversation the other day with an investor about a property they had just sold. They said something to the effect of, “We cleared $130-thousand. We have to pay off $99-thousand in outstanding loans. So we made $31-thousand.”
Wait a minute! That’s cash flow. And immediate cash flow at that! What about all the money you spent on renovations and holding costs?
We sat down and figured up everything they had actually spent. It turned out they made closer to $21-thousand than $31-thousand. Still, that’s not a bad pay check.
Previously Expensed Costs
The situation gets even stickier when a project crosses over year-end. Then you’ve taken some of the expenses against the previous year’s income. But those expenses still have to be subtracted from the sales price of the project to know what your actual profit is. You just have to be careful to not try to write them off twice.
Hermann says please like and share!