Assets and Liabilities
In the world of finance, the two most fundamental concepts are also the two most easily misunderstood: assets and liabilities. Telling them apart correctly is the first key to financial freedom.
Traditional accounting definitions can get rather complicated, but Robert Kiyosaki gave an easy-to-understand one in Rich Dad Poor Dad:
Definition
A definition is a precise description of what a concept, a term, or an object means. Understanding definitions is the foundation of learning any field, and every concept has its own exact meaning.
- Assets: things that put money into your pocket.
- Liabilities: things that take money out of your pocket.
Examples
| Item | Could Be an Asset | Could Be a Liability | How to Tell |
|---|---|---|---|
| A house | Rented out, with the rent still covering the mortgage and the running costs | Lived in yourself, so you pay the mortgage, management fees, and repairs every month | Whether it produces a net cash inflow |
| A car | Driven as a ride-hailing car or rented out, so it generates income | Used for yourself, so you pay fuel, insurance, and servicing | Whether it generates income |
| Stocks | Pay dividends or appreciate in value | Keep losing money | The investment return |
Once you understand assets and liabilities, you can calculate a person’s net worth.
Definition
A definition is a precise description of what a concept, a term, or an object means. Understanding definitions is the foundation of learning any field, and every concept has its own exact meaning.
Net Worth = Total Assets - Total Liabilities
Net worth is the most important indicator of a person’s true financial condition.
- Total assets include: cash, deposits, stocks, funds, the market value of property, gold, and so on.
- Total liabilities include: the outstanding balance of your mortgage, the outstanding balance of your car loan, credit card debt, loans, and so on.
Not necessarily.
If both the luxury car and the mansion were bought entirely on credit, then the value of their assets (the car and the house) may only be slightly higher than, or even equal to, their liabilities (the loans). Once depreciation and interest are taken into account, their net worth may even be negative.
Real wealth is not what you show, it is what you own minus what you owe.
- Paper assets: stocks, bonds, funds, options, and so on. Good liquidity and a flexible entry threshold.
- Real estate: homes, shops, offices, REITs. Usually requires a large amount of capital, but has the property of resisting inflation.
- Physical assets: gold, silver, artwork, collectibles.
- A business: an enterprise you own that runs by itself and generates profit.
- Consumer debt: credit card balances, consumer loans (such as a new phone or a holiday). The interest rates on these are usually high, so they should be paid off as quickly as possible.
- Secured debt: mortgages and car loans. These are usually backed by collateral, so their interest rates are relatively low.
Based on the definitions of assets and liabilities, the logic for improving your finances is very simple:
- Increase assets: buy or create assets that generate cash flow.
- Reduce liabilities: repay high-interest consumer debt first, and curb unnecessary borrowing.
- Optimize the structure: let the income generated by your assets (passive income) gradually cover both the payments on your liabilities and your living expenses.
The rich buy assets, the poor only have expenses, and the middle class buys liabilities that they think are assets. — Rich Dad Poor Dad
Terms Used in This Article
| English Term | Explanation |
|---|---|
| Assets | Resources that bring cash inflows |
| Liabilities | Obligations that cause cash outflows |
| Net Worth | What is left after subtracting liabilities from assets |
| Cash Flow | The direction in which money moves |
| Passive Income | Income that comes without continuous work |