Today I want to talk about a key area of personal finance and business as a whole: Assets and Liabilities. This is a must know for anyone that wants to gain sustainable wealth within their lifetime and leave a legacy for future generations. Today you will learn this fundamental of financial knowledge and how you can benefit from this moving forward in your life.
Without further ado – let’s dive in!
What is an Asset?
Assets can be referenced in two forms personal assets and business assets. In this article we will only reference personal assets.
Personal assets are items that have present and future value that are owned by an individual or household. Personal assets can be identified as the below items:
- Cash and cash equivalents – for most people this is the cash balance that you have in your bank accounts.
- Property or land.
- Personal property – these are often depreciating assets that decrease in value from the day of purchase (furniture, most cars, most collectables etc.).
- Investments – stocks, bonds, pension accounts, mutual funds, annuities.
- Businesses – that you own or part own.
These are recorded on the left hand side of a balance sheet (a financial statement of liabilities and assets). You will see this later on.
What is a Liability?
A liability is something that an individual or company owes to another entity. You will most likely refer to these as your debts to others that need to paid over a period of time or in the future. Below you can see a list of liabilities that you may come across:
- Car Loans
- Student Loans – in another article I will touch upon why you should see this as a tax if you have studied in the United Kingdom.
- Credit Card Balance – if not paid in full each month (you should be doing this!)
- Payday Loans
- Personal Loans
You need to ensure that you keep these under control and ensure that your assets outweigh your liabilities. Understanding what assets and liabilities you currently have will allow you to gain a clear picture of your net worth.
Assets and Liabilities: Why do they matter?
Whether you are just starting to get a handle on your finances or you are a financial veteran, you will probably have heard of the book – Rich Dad Poor Dad by Robert Kiyosaki. Selling over 32 million copies worldwide – this book provides a gateway into personal finance. He uses assets and liabilities at the heart of this book stating:
“You must know the difference between an asset and a liability, and buy assets…. Rich people acquire assets. Poor and middle class people acquire liabilities, but they think they are assets.”
This is key to understanding why assets and liabilities are important to anyone that wants to pursue financial freedom and personal wealth. Furthermore, the book defines anything that takes money out of your pocket as a liability and anything that puts money into your pocket as an asset. This definition is not necessarily true in terms of accounting – but is a great way to understand resource allocation.
The idea is to ensure that your money works hard for you and not the other way round!
Below we will head into the detail of how Kiyosaki identifies the cashflows of the poor, middle class and rich. These are highly related to the level of liabilities and assets an individual has.
Poor Cashflow & Assets
Firstly the poor cashflow.
Here we see an individual that has a job that provides a salary. This salary is provided to the individual based upon the value that the employer places on that individual (whether this be the correct value is another story).
As you can see below this individual will have a single stream of income that can be pulled from underneath them. They will also trade there time / life force (the one thing we cannot gain more of) for money.
Once they receive their salary they will spend there income on expenses. These can be in the form of rent, utility bills, food, transportation and clothing – to name a few.
At the end of the month they are left with nothing and the cycle continues.
Middle Class Cashflow & Assets
Secondly the middle class cashflow.
Once again we see a similar income stream to the poor cash flow above. Once again the individual trades their time in exchange for money. The only difference being the total income is higher (the value placed on the individuals time by the employer).
Upon receiving their salary, often the vast majority of their income will be used to pay off the liabilities they have accumulated. These liabilities come in the form of loans, mortgages, credit cards and items that have been purchased on finance.
In most cases the middle class believe that they are living a life of wealth by purchasing items above their means. The liabilities that they have amassed have been used to purchase items that they believe are assets. These items are, at most, depreciating assets such as a car that they have bought on finance.
The middle class have often overstretched themselves and have fallen foul to lifestyle inflation (spending at their income level or above with each and every pay rise).
They may have accumulated savings over the time that they have been employed. However, they are still continuing to work for their money with no asset to their name. Even though they think they have “assets” it is often junk that can be sold for a fraction of the price paid.
Rich Cashflow & Assets
Finally the rich cashflow.
Here we see the key to wealth building and what you need to do in order to gain financial freedom. You will notice that the rich individual has a mass of assets on their balance sheet that significantly outweigh their liabilities.
Note that in this case we have only included assets that produce an income stream for the individual. The rich individual does not rely upon a salary as the income from their assets have replaced or exceeded their employer’s benefits. These income producing assets provide multiple streams of income for the rich individual.
- Real Estate provides rental income.
- Stocks provide dividends.
- Bonds & Notes provide interest paid after a period of time.
- Intellectual Property provides royalties (books, music, courses, software to name a few).
This income then pays for the expenses and liabilities of the individual and the remaining income is reinvested. This leads to the power of compounding where the assets continue to grow over time – increasing the income for the rich individual. In most cases these income streams become passive overtime with the initial time invested from the individual.
The rich individual will ensure that they use liabilities / debt within their life as leverage to gain assets. These assets, as previously discussed, will gain value over time or produce further income for the individual. They will not use debt to finance expenses and items of depreciating value.
The key here – the rich person does not trade their time for money allowing them to use their time to pursue and explore their passions and goals in life while building a lasting legacy.
How are you spending your hard earned cash?
So based on the above where do you fit?
Hopefully from this article you will be able to apply the rich cashflow to your life. Think about the cashflow of your money every time you receive income. Ask yourself the following:
- Are you spending your hard earned money on assets or depreciating items?
- Do you have multiple streams of income?
- Are you reliant on your salary for income?
- Do you have any income producing assets?
- Do you know your net worth?
- Are you financing your expenses through debt? Do your liabilities outweigh your assets?
I hope the following has provided an overview of assets and liabilities and how these are a cornerstone to financial freedom. Remember the goal here is to ensure your money works hard for you!
Not sure where to start with investing your time and money in assets?
Check out the Invest area of The Long Commute.
Need to free up some extra cash and gain a secure foundation before you start to invest in assets?
Check out the Saving area of The Long Commute.
Need to increase your income and build another stream of income?
Check out the Hustle area of The Long Commute.