Which Is More Important - Investing In Cash Flow Or Capital Gain?
A diligent consumer who is thinking of investing hard earned income will undoubtedly
come across the two, apparently conflicting concepts of cash flow and capital gains. This article will provide the reader with a simple definition and examples to aid in their understanding. By the end of this article the reader should know the answer to the question posed by the article and have a deep understanding of the reason behind the answer.
Cash Flow Defined - Simply put, cash flow is the solvency of a particular individual or business. Solvency means the ease at which stocks in trade, finances, investments, income, etc. gets converted into cash or liquid capital. Investing for cash flow is important because it allows the business to go about with its daily tasks, in that creditors are paid, stocks are replenished, and income is regularly generated,
For example, Mr. A has 3 investment properties subject to a real estate mortgage. These properties are rented out in the normal course of business. These properties earn rental income on a monthly basis. This is essentially investing for cash flow of the rental property in that the rent being paid is used to pay off the mortgage, regular expenses, and also save up for taxes and necessary repairs. Without cash flow Mr. A will most likely default on the amortizations and lose the property.
Capital Gains Defined - The simplest definition is the amount over and above the purchase price of capital asset. Capital asset is defined as any property not usually sold in the regular course of business. For our purposes then capital gains is the difference between the current market value and the purchase price of a capital asset.
For example, a capital asset is usually real estate property not held to be sold in the regular course of business. If 5 years ago property A was bought at $150,000 and today the property A is worth $200,000 then the capital gain for property A is $50,000.
Which is More Important? The answer depends on the purpose of the property. If the property is held in the normal course of business then investing for cash flow is necessary. However if the property is not in the inventory or is a capital asset then cash flow for that property is not important in the short term because it is being held for the benefit of the owner. In the instance that the capital asset is used for the benefit of the stock in trade which generates cash flow then to a certain extent the capital asset contributes to that cash flow. Therefore in the final analysis both are important and must be present in order for profits to be realized.
For example, if Mr. A is in the business of renting apartment units and has an office space owned by him for the purpose of conducting business. Cash flow is generated by the real estate properties for lease and capital gains is generated by the office space used. However to a certain extent rentals will not be as brisk if there is no office to conduct business. Hence the capital asset also contributes to the cash flow.
by: William WL Tan
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