How do you define assets and liabilities? You will need a thorough understanding to achieve your goal of becoming financially free.
Over the course of my research, I asked nearly everyone I knew to define the terms Asset and Liability. Amazingly enough I never heard the same answer twice. I heard a lot of good explanations, a few very creative ones, and some that were just flat out wrong.
My conclusion is that these terms are simply abstract concepts and, as such, their definitions are open to interpretation. They do not mean the same thing to everybody, so any conversation relative to this subject matter is likely to get confusing. Therefore, it is important for you to understand my personal definitions of the terms in order benefit fully from the information in this chapter.
If, after having read the verses, you disagree with my perspective than so be it.
“Efforts to obscure the truth will not and cannot change the facts.” -Bruce Babbitt
A definition of the term asset that you might get out of a dictionary would read something like this:
An asset is an item of value that can be owned
While this definition is sufficient for a CPA, and in fact is widely accepted by the accounting profession, I believe it to be somewhat incomplete and misleading. While the main thrust of this definition is obviously with regard to ownership of value, this definition fails to provide the basis upon which this value is defined. To this end, I have learned that all assets can be placed into one of three categories relative to cash-‐‑flow: positive cash-‐‑flow assets, neutral cash-‐‑flow assets, and negative cash-‐‑flow assets. Items in all three of the above categories store intrinsic value, but they have very different characteristics relative to income-‐‑potential and therefore their impact on the owner’s financial position varies. As they say – the devil is in the details.
Positive Cash-Flow Assets
Assets in this category are items which generate passive cash-‐‑flow on behalf of the owner, meaning that the expense of ownership of such an asset is less than the income it generates. Once the investor buys or builds one of these assets, even if it is necessary to borrow money to do so, the asset will continue to bring-‐‑in passive income in perpetuity provided it is well managed by the investor. And as long as this income is greater than the expense of borrowing the money, the asset will generate positive cash flow. In addition, besides making money throughout the life of the investment, these assets can also generate capital gains upon liquidation. Though, in this way cash flow assets are similar to the other asset categories. Some examples of this type of asset are a business, rental property, automated car-‐‑wash, a franchise, dividend stocks, etc.
Neutral Cash-Flow Assets
Assets in this category are items which don’t generate cash-‐‑flow, but also don’t cost the owner on an ongoing basis following the initial acquisition. This means that the only way to make money with these assets, unlike the ones in the previous category, is to buy them low and sell high. When investors buy these assets, they often hope for appreciation in values over time. This is generally the only way to make money with this type of investment. However, since the investor has no real way to positively impact the value of his investment then I consider this form of investing to be purely speculative in nature and more of a gamble than anything else. There are too many factors that are outside of the investor’s immediate control to trust it.
On the other hand, acquisition of these assets has the obvious advantage for the average investor in that these investments require virtually no management. An investor buys the asset, holds it for a period of time, and hopefully sells for more money than he paid. That’s it. The drawbacks being that there is no income stream and one is “hoping” for the value to increase. Some examples of these are equity stocks and bonds, antique paintings, antique cars, musical instruments, coins, precious metals, etc.
Negative Cash-Flow Assets
Let me begin by qualifying that while your accountant will view items in this category as assets, I do not. While classified as assets simply because they have value, these items actually impact the owner’s financial position in a negative way by continually costing the owner money. For example, how many people do you know who are deeply in debt because they bought bigger homes assuming that those homes will increase in value every year like clock work? For some inexplicable reason, they never seem to be bothered by the fact that they spend an ever-‐‑increasing portion of their take-‐‑home pay on a gamble. Furthermore, while homes do go up in price in America over a long period of time due to inflation, to assume that this is a guarantee is wrong – especially when buying at the top of the market. The phrase house-‐‑poor has become a proverb and a truism over the last decade. As a result, a lot of folks are stuck with homes whose value is currently less than the balance on their mortgage. These people are screwed on both ends. They have a home where the value has fallen but the expenses associated with its ownership remain high. All because they justified the purchase by choosing to believe that a home is an asset. It is not. It is merely a roof over your head which costs you money every day.
I see people throwing money at their IRA and 401k accounts out of blind faith all the time. It seems that they assume their money manager (with talents on loan from God) will ensure growth of their portfolio regardless of the economy. “Investing” money in IRA’s and 401K accounts does not qualify for investing in my world. I see this more as spending money to save money rather than investing money to make money. Another thing that gets me is why this type of “investor” is willing to accept that his money manager WILL get paid a commission whether his portfolio makes money or losses money.
Think about this sensibly. An investor’s equity can go up or down, but the manager’s income just goes up. I don’t know about you, but to me this seems to be a better arrangement for the money manager and his broker than the investor. Even though these retirement accounts are classified as assets, I personally do not know anyone who has achieved financial freedom through the use of any such investments.
All assets are not created equal. The main distinction being that some assets make money while others cost money. Though all items of intrinsic value appear on the balance sheet and add toward the owner’s net worth, only the positive cash-‐‑flow assets have a positive impact on the owner’s income & loss statement. To investors like me, whose ultimate intent behind any investment is cash flow, value resides almost exclusively in income-‐‑potential. In my world, intrinsic value means nothing while cash flow means everything. As such, the only true assets in my book are positive cash flow assets. I believe that it is very important for you to understand this distinction among assets, because financial freedom is built around positive cash-‐‑flow assets, while the other types of assets, though they may have value, are useless or worse, detrimental to financial freedom.
The financial accounting profession defines a liability like this:
Liability is an existing debt or obligation of one party to another which requires some form of repayment.
This definition would have us believe that every kind of debt is a liability simply because it has to be repaid. In technical terms this is correct, but I think that it is counter-‐‑productive to consider debt in these black and white terms. The fact is, all debt costs money and as such all debt is a liability. However, if it were possible to apply debt in such a way that it actually earns money, wouldn’t it qualify as an asset according to our definition of an asset? Here is an example.
Let’s say you find a rental house that you can buy for $50,000 and rent for $700 per month. Your options of buying this house are either to pay cash for it, which you can do only if you have fifty thousand smackers sitting in the bank, or you have to finance it in some way. Let’s say that after you buy this house, the mortgage costs you $300 per month. But since you can rent it for $700, you are making money every month. We define asset as anything that makes us money, right? What made it possible for you to make money in this example? The mortgage did, because you couldn’t have bought the house any other way.
Now, I know that when you call your accountant tomorrow, he or she will tell you that in this situation the house is the asset, while the mortgage is a liability; the house earns the income while the mortgage costs money. But I tend to think that seeing it this way can have the effect of closing your mind to the reality that debt can make you rich if properly utilized. The reality is that you would have neither the house nor the cash flow from it if it weren’t for the debt. I, for one, intend to have as much of this type of debt as possible because the more of it I have, the more positive cash-‐‑flow assets I can acquire. Thus, I define liability as follows:
LIABILITY is any item which costs more than it earns on a monthly basis.
If you borrowed money to buy a car, a TV, or new furniture, then the items that you received in exchange for assuming this debt are all liabilities. You will owe the bank a payment each and every month until your loan is paid-‐‑off, while the purchased items do nothing to contribute to your cash situation. Keep in mind that your accountant will enter these items as assets on your balance sheet simply because they have intrinsic value. Hopefully when you get tired of them you can sell them for more than you owe on your loan!
Liabilities in terms of debts and credits
The concepts of debt and credit have to be given a thoughtful examination, specifically in the context of an asset vs. liability discussion. All things in life are relative. The notion of the coexistence of positive and negative, good and evil saturates the world. Financially-‐‑speaking, this juxtaposition is sometimes more apparent, as in the case of income and expense. Other times, as in the case of the concepts of debt and credit, the lines are a bit blurred.
In most basic terms, debt is one party owing something to another. In other words, the lending party has chosen to extend credit to the borrower. Interestingly, these basic definitions do not take into account how the borrowed funds are to be used, but that is precisely what determines whether the debt and credit are “good or bad”. In the world of business, the cost of borrowing money is just another cost of doing business. As such, if you were able to borrow money at a cost of $400 per month, and then put this borrowed money to work earning $500, then this debt would actually be making money for you – we call this making money in the margin. This is an example of good debt and credit.
Good debt makes money in the margin
Drive through the downtown of any major metropolis and take note of the tallest buildings there. Who owns them? The answer is insurance companies and banks. What is their basic business model? They borrow money at a low cost from you, and lend it out at much higher cost back to you. In other words, they use your premiums and deposits to lend money to consumers. They make lots and lots of money in the spread; enough to own the biggest buildings in downtown. On a much smaller scale this is exactly what I do. I borrow money to buy a house at a cost of say $400 per month, and rent it out for $600 month. The mortgage that I owe to the lender is an example of good debt because it makes me money in the margin.
Consumer debt is bad debt
On the other hand, many people borrow money to update their house, spruce up their wardrobe, or take a vacation. Regardless of the reason, since there is no income being generated to offset the cost of borrowing the net result is negative. This is bad debt – also called consumer debt. This is where most people get themselves into trouble.
The concept of good debt vs. bad complicates the issue of asset vs. liabilities. In my opinion, the most pertinent condition of an asset is with respect to cash flow. Does the item in question generate more income than expenses associated with the ownership of item?
How debt can make you money
Here is the thing; debt can in fact make money when used appropriately, in which case the debt should be classified as an asset. And yet, I have never met an accountant who would classify debt as an asset under any circumstances. Since debt and/or credit are neither good nor bad in and of themselves, this is one instance when it really pays to be educated. You have got to know how to use debt and credit in ways that benefit your bottom line. People who understand how to make money in the margin know the real difference between an asset and a liability.
How to tell an Asset from a Liability
The universe of assets and liabilities involves a very large gray area, especially in terms of debt and credit. An easy way to cut through the nonsense is to ask yourself the following question: will this item help pay my family’s bills if I become unable to earn income, and if so -‐‑ for how long? If the answer is yes-‐‑it will, than the item in question is likely an asset, especially if the time-‐‑frame is forever; if the answer is no, then the item is likely a liability. Having said this, I must qualify that it is almost never the item itself, but rather its end use that determines whether it is a liability or an asset.
Let’s consider some of the most common items of value which could swing either way depending on their use.
When buying a house most people, me included, have to finance most of the purchase in some way. This, of course, creates debt which costs money. If upon purchasing a house you proceed to move into it, it becomes a liability because there is no income generated by this house to offset the expenses of the debt associated with it. Remember, we do not define asset respectful to a perceived value, but rather the item’s capacity to improve your income. On the other hand, if you rent the house to a tenant for an amount greater than your expenses, then the house becomes an asset because at the end of the day it generates income which is greater than the costs. This benefits your bottom line!
Equity Line of Credit or Equity Loan
We’ve already established that the home you live in is a liability because it costs you money. As to the equity, the answer is two-‐‑fold; it is an asset since it adds to your net worth, but it’s not an income-‐‑producing asset. However, if you were to borrow money against your home to use as a down payment for a rental property that will generate more income than what is needed in order to cover the payment on this borrowed equity, you would convert the equity into an income producing asset. Even though this process involves borrowing money and therefore creates debt, since the end result is positive cash flow, you would be successfully converting debt into an asset.
On the other hand, if you borrow against the equity to by a boat or remodel your house, then you would be creating a liability since these items will not make any money for you.
Retirement plans such as an IRA or a 401k
Retirement accounts add to your net worth and are listed among the assets on your balance sheet. However, until you actually retire they make no positive impact on your income & loss statement. In fact, they actually cost you money since you have to make room in your budget to contribute to them. These investment vehicles are fine for people who are satisfied with average returns and do not want to manage their own investments, although I personally challenge their “asset” status based on recent history of their overall effectiveness.
If you are an electrician or a painter and you’ve bought a vehicle for your business, and your business generates more income than all of its expenses then the vehicle is an asset to the business. However, if you bought the car for your personal use then all it does is cost you money since even if you own it free and clear, you will still have the expense of service, insurance and tags. In this case the car cannot be classified as an asset in my opinion, regardless of its value.
Debt and credit have created fortunes both big and small for many men and women throughout time. This is especially true when used in conjunction with real estate. However, they have also ruined many a person’s best plans when used irresponsibly. Educate yourself so that you can learn to use debt and credit to make you rich, otherwise you could end up a slave to the bank and the boss man for the rest of your life.