Where do you Fall in the CashFlow Quadrant?

16 Jan 2020 Read 3364 Views

Everybody wants a future that is better than their present. Most people want to be richer in the coming time of their life. Is there a secret that only the rich know; or is it a code that one who cracks, becomes rich?

There are plenty of theories explaining what rich do differently that they get richer, and what wrongs do poor commit that they are doomed to stay poor. A lot has been written about how changing one’s attitude can start building one’s wealth.

One such concept that clearly explains this is ‘Cash Flow Quadrant.'

 Active and Passive Income

Before we delve into the details of the quadrant, we should first understand the concept of active and passive income. In simpler terms, the income you earn as wages for your job, like your salary, is called active income. It involves a certain kind of activity. You work for money.

The other income is passive income. In this case, you use your money to create more wealth without any activity. It is like an investment. Say you buy a house and rent it. This rental income is your passive income. You don't have to work for it. Your money works for you. As Robert Kiyosaki describes it, "You earn money while you are sleeping."

On similar lines, your salary or income from the business is active income, while your returns from investments are your passive income. Entire Kiyosaki’s philosophy is around maximizing this passive income.

The First Quadrant: Employed (E)

Most people in the world belong to this quadrant. They want skills that pay high. However, these people 'trade their time for money'. It means that if one wants to earn more, he will have to put in more hours (efforts). They may keep switching jobs whenever they want higher pay.

These people look for security in their lives and avoid risks. They do not get into the business, thinking it to be risky. They do not have any passive income.

The Second Quadrant: Self-Employed (S)

These kinds of people have high standards of working. They are much tolerant of risks. Hence, they work for themselves.

Doctors, Lawyers, Accountants, Consultants are some of these people. They do not think they can delegate their work. They do not hire other people. This means they can earn only while they are at work.

Though they have better control over their lives yet, if they need more money, they will work for more hours. Resultantly, they have a job, not a business.

The Third Quadrant: Business Owner (B)

They are risk-takers. They create a system of product or service that enables them to earn even when they are not working.

They know they would need people for it. They hire talented folk. They delegate their work as much as possible and do not work all by themselves. Here it is where they are different from self-employed. They may leave their system for a while and still, it will be working. They just manage the employees.

For them, being a job seeker is risky. You may be fired in a slowdown. Hence, when they need more money, they create (or acquire) a new product or new system that generates money for them.

The Fourth Quadrant: Investor (I)
  • They are the best in all four. They find the assets that give them enough returns. Sometimes they use other people's money to acquire those assets. The more assets they create, the more cash flows in and using this cash, they acquire even more assets. They do not spend time managing the employees.

Most of their income is passive income. In fact, as much as 70% is passive income that is returned from investments, and only 30% as wages.

The Two Halves

We discussed the traits of the quadrants. There is still a difference in characteristics of the left and the right.

The E&S: As one can see, this half of the quadrant does not invest. They work and their money is only proportional to their work. They have no passive income. Since they have no passive income, they do not care for their debts and taxes.
The B&I: This half has a system that generates passive income for them. Even if they do not work, some portion of their income would still be available to them. They take advantage of most tax breaks.
How the Rich Gets Richer?

The left half group (E&S) pays the highest tax, and they are under maximum debt.

For instance, say a person from this group buys a car. The person has to pay the tax on the salary. She also has to pay the tax on the car. They would also have to keep paying the monthly installments of the loan taken for this car.

Instead, if the person on the right half (B&I) buys a car, he can legally buy it in the name of his business. All the tax on the car is exempt because it is classified as 'logistics.' The amount spent on buying the car is deducted from taxable income, and the person has to pay less tax.

Similarly, tax paid on income is much higher than the tax paid on Capital Gains.

While the left half people keep spending over unnecessary fancy stuff, the right half spends on buying assets and creating new products. When E&S people would be throwing away their annual bonuses on liabilities (buying some stuff that does not create money), B&I would spend it on new avenues. Later, when these assets pay their returns, they would have much more money to spend.

E&S people believe in earn and spend. They forget that their money will be eaten by inflation. Say you have ₹ 100 today. A car too costs ₹ 100 today. Now, since the inflation rate in India currently is 7.5%, the car would cost ₹ 107.5 next year. Meanwhile, your ₹ 100 stays the same. It means your money has lost the value. If you still want to buy it, go work harder and earn another ₹ 7.5.

Contrarily, a B or I kind of person might have invested this ₹ 100 in a mutual fund. If it returns with a reasonable CAGR of 12%, he would have ₹112 next year. Not only can he buy the car, unlike E or S person, but he will also save ₹5. The money has rather grown. He beats the inflation in its own game.

The Winding Down

If you are in the left half, move to the right half as quickly as possible. If you are a B person, become the I person. It is not very tough.

E & S people have a short-term vision and they want instant gratification. The mantra for becoming the I person is to have a long-term vision, not to be lured with instant gratification, and trust the power of compounding. The choice is clear.

About the Author: Vivek Tiwari | 46 Posts

Vivek Tiwari is a Software Engineer and a Data Scientist who hopelessly fell for Economics. His plans to move to Finance might now save mankind from his IITJEE selection story.

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