How Hard Is Your Money Working For You?
The power of knowing your Return on Investment
Last week, I wrote, “When I’m investing, my first and primary focus is cash flow,” and explained why. But the reality is that when it comes to investing, cash flow isn’t the only thing I pay attention to.
In my investments, I have two key focuses: cash flow and return on investment (ROI), which goes hand-in-hand with cash flow.
What is ROI?
Your return on investment is exactly that: the amount of cash the money you invested is paying or returning to you. In other words, how hard is the money you invest working for you?
K.I.S.S. (Keep it super simple)
There are several ways to calculate return on investment depending on what you’re measuring. Some are more complicated than others.
Some formulas take depreciation into account when calculating ROI. Another formula assumes that the cash flow you are receiving is being re-invested immediately and takes that into account. Each formula is accurate, depending on what you want to measure.
Personally, unless it’s absolutely necessary, I like to follow the K.I.S.S. principle and keep my calculations super simple. So, when I refer to ROI, I typically mean what is called cash-on-cash return on an investment. After all, I’m only interested in one thing: how much cash is flowing into my pocket. It’s all about the cash flow.
Calculating cash-on-cash return
Figuring out your cash-on-cash return is easy. The equation is:
The annual cash flow / Amount of cash invested = Cash-on-cash return on investment
For example, let’s assume you’re buying a rental property that costs $100,000 using a 20 percent down payment of $20,000. Each month your property cash flows $200. That’s an annual cash flow of $2,400. To calculate your cash-on-cash return would look like this:
$2,400 / $20,000 = 12% cash-on-cash ROI
Not a bad return, but not stellar either.
Let’s take a look at another example. Say your purchase $2,500 in stock that pays an annual dividend of $100.
$100 / $2,500 = 4%
Well, at least you’re getting a return.
Smarter investments = higher ROI
The point of showing the two examples, a rental property and a stock investment, is to illustrate that not all investments are created equal. Understanding how much cash flow you’re making and what kind of ROI that cash flow represents helps you to know how hard your investments are working for you.
The whole reasoning behind focusing on cash flow is that you want your money working hard for you so that you don’t have to work hard for your money. If you have an investment making 4 percent ROI for you, then it’s not working very hard. If, you have one making you 50 percent ROI, well then you have a real team member.
Check out these Rich Dad tools to help you measure the health of your investments.