Personal Finance Musing 12: Understand Assets and Liabilities

SEVEN WEEKS FOR THE BOOK LAUNCH

“MUSINGS OF A (FINANCIALLY) ILLITERATE FATHER”

MUSING 12: UNDERSTAND ASSETS AND LIABILITIES

I will begin this post with my impassioned plea - please keep sharing these posts with your near and dear ones especially young adults, for these are a run up to my book, “Musings of a (financially) illiterate father, likely to be in your hands by mid-July. The book has been specially written to teach the alchemy of wealth creation and retention to our children and they deserve to learn it.

This week, I was to cover my experiences in the world of publishing but have decided to postpone it a bit as my book is still being edited with other associated publishing activities in advance stages. In a couple of weeks, as the book reaches "four weeks to go" mark, I think I will be in a better position to share my experiences. This week I will instead cover a very important topic which is a sine-qua-non for our children to understand, the earlier, the better- the difference between Assets and Liabilities.

If you recall my musing 6, posted on 08 Apr, it covered the aspect of spending-investing (SI) balance in detail. I will request you to go back to reading that musing before getting to current musing. SI balance teaches us this all-important money management thumb rule of 50:30:20, but leaves another question unanswered- can one go ahead and spend money on anything one fancies, so long as SI balance is maintained?

https://andysfinancial.blogspot.in/2018/04/musing-6-si-balance-in-real-life.html

There are competing needs for various things in life with the only finite amount of money at our disposal. A few outings with friends (wants) are no less important than investing money in mutual funds (needs) for a youngster. How do we go about prioritizing our needs and wants? Is there a guideline or precept one can follow? Well, actually there is one, and explained very beautifully by Robert Kiyosaki in his book, “Rich dad Poor dad”, which I covered a few weeks back. Kiyosaki states that we must understand the difference between an Asset and a Liability and then endeavour to acquire the most number of assets while keeping the liabilities to a minimum. 

          As per Kiyosaki, an Asset is the one which puts money in your pocket, whereas a Liability takes money out of your pocket. Let's try and understand with the example of a Smartphone which straddles the space between a want and a need. For our communication needs, a Smartphone is definitely required and hence a functional and decent looking Smartphone could be construed an asset. It helps you to remain in touch with your family, friends and other near and dear ones. It keeps you abreast and alive to happenings in the world. One can read, watch movies, do banking and other tasks which save time and money, both in short and long-term. However, does it really put money in our pocket? If we decide to sell our Smartphone the very next day of its purchase, we might just about get half the price. So its price keeps going down with time as also it requires periodic expenditure on maintenance for replacing Battery etc. It is thus difficult to slot it into the category of an asset.

The deduction is that if one spends a little sum of money to buy a Smartphone which has all basic required functions and is decent looking, it is still an asset. However, spending Rs one lac to buy an “I phone- X” could firmly put this purchase in the category of a liability, especially if the purchase is out of our regular Income or Pay. Does this mean we should not aspire to buy an “I phone- X”? Definitely not, but the money must not come out of our regular Income but from our Assets itself. To understand this point, let’s first summarize what all could be clubbed under the category of Assets?

          Your investments which generate a cash flow in short/long term are your Assets. So, equity (Stocks and Mutual Funds), Bonds, Income generating Real Estate, Gold etc. come under the category of Assets. Notice, that these also take money out of your pocket initially to acquire but overtime appreciates in value and return not only the original amount but grow it manifold. Getting back to our aspiration to buy an “I phone- X” Smartphone, we should invest the money in assets (e.g. mutual funds) and when these assets appreciate to give us Rs One lac; we should go ahead and buy. But that will obviously take time and hence we need to write down our wants and aspirations, prioritize them, put Rupee value to them and then go about Saving/Investing towards acquiring them. In short, we should ruthlessly curb our “present bias”- the voice of that little kid inside us who wants everything “right now”.

          Liabilities are then obviously which not only take money out of your pocket to acquire but thereafter to be maintained as well. They also depreciate in value over time. So everything from a car to furniture items and other consumer goods could be put into this category. Obviously, most of these things will also overlap the space of a Want and a Need. One way to acquire them has already been discussed with the example of a Smartphone. Another way is to do a VED (Vital, Essential, Desirable) analysis, prioritize them and then buy out of the Want/Need  Money (remember 30%/50% bucket of SI balance).

          The 20% saving/investment bucket will be utilized to build Assets which cover your long-term goals like Retirement, Children education and marriage etc. and not short-term Needs/Wants as discussed above. They have to be managed under Needs (50%) or Want (30%) money. 

A peculiar case is of a House which is an aspirational and security need for most of us and often the biggest investment which runs for the longest period of time. This topic generates a fair bit of controversy about a house being an Asset or a Liability and for these reasons, we will tackle this issue subsequently as a separate musing. But as an aside, just check with your banker from whom you have taken the home loan, in which column (assets/liabilities) he slots your house? Your house is an asset to the bank as is your dear car (if bought with a loan).

          Kiyosaki also discusses the Cashflow Quadrants of a Rich, Middle Class and Poor person which are instructive and have been covered by me in musing 10, posted on 13 May. Just to recapitulate, it basically says that Rich persons use their Income to build Assets whereas Middle Class and poor persons acquire Liabilities which they think are Assets. So, a Rich person will buy an “I phone- X” out of money generated by his Assets whereas a Middle-Class person will buy it out of his Pay or regular income. I will once again urge you to read this wonderful book, “Rich Dad Poor Dad” and internalize the Cash Flow Quadrants.

https://andysfinancial.blogspot.in/2018/05/personal-finance-musing-10-seven-key.html

          Very clearly, you cannot and will not become rich by mere pay raise because invariably it will be accompanied by rising expenditures to maintain your lifestyle. We will become rich only by acquiring assets and eschewing liabilities- thus increasing our net cash inflow.

          Next week, on 03 Jun, I will review another wonderful book on personal finance- “The Millionaire Next Door” written by Thomas J. Stanley and William D. Danko. This book is based on the lives of real American Millionaires whom the authors researched and is truly awesome in its deductions. For now;  enjoy your Sunday- you have earned it.

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·        Key Takeaways.

o   Understand the difference between an Asset and a Liability and acquire as many assets as you can while keeping the liabilities to the bare minimum.

o   A dispassionate VED Analysis will help to put the Liabilities in correct perspective.

o   Over time, how much your regular income increases will become immaterial if you manage to build income through your Assets including for the time you have no regular income coming in-after Retirement.