This lesson ‘What are assets and liabilities in personal finance?’ will create a lot of value for you. Assets and liabilities are the two most important words used in finance. But, a few people know their relevance to personal finance. Those people who choose a career in finance are well aware of these two terms, but they are far from reach for a common man. Thus, a common man struggles financially throughout his life. However, in schools and colleges, we learn these terms from a business point of view.
I don’t know why they don’t prefer to explain it in a more personal way than the other. Perhaps, they are preparing us to work for the businesses, not to own a business. They prepare us to work for money, but don’t teach how to make money work for us. In this lesson, I will introduce to you what assets and liabilities are from a personal point of view and how you can apply this knowledge in your money management to take you to the next level.
What are assets and liabilities?
In the following paragraphs, I am going to introduce you to assets and liabilities from different perspectives. Though the main focus will be on a personal point of view, a brief introduction of these terms will also create value from a business point of view. If you an investor or planning to invest in companies, then understanding both these concepts will empower you. Let’s begin.
What are assets and liabilities from a business point of view?
In simple terms, assets are something valuable that a company or business owns. Therefore, the land, the buildings, the pieces of machinery, the raw materials, money they have to receive from others, and the cash they have, cash in the bank, and their investments are assets. They make money using these things.
We can divide assets into two categories from a business point of view. They are current assets and fixed assets. Current assets are those assets that can be converted into cash within a year. For instance, capital, raw materials, etc. are expected to be sold or used within a year. Likewise, Fixed assets are those purchased for long term purposes and are not likely used up within a year. For example, land, buildings, equipment, furniture, vehicles are not going to be used up within a year or so.
On the other hand, liabilities are something that a company owes to others. Therefore, bank loans, unpaid bills, mortgages, salaries, or wages of the employees are liabilities for a company. The company has to pay it to others.
Again, we can divide liabilities into two categories. They are current liabilities and noncurrent liabilities. Current liabilities are those liabilities that the company has to pay within a year. For instance, unpaid bills, salaries or wages, interest on the loans, income taxes, short term loans from suppliers, etc. are to be paid within a year. Likewise, noncurrent liabilities are those liabilities that the company need not have to pay within a year. They are usually on term debts. For example, long term bank loans, long term lease renewals, long term bonds, obligations, employees’ pension benefits, etc. fall under noncurrent liabilities.
Understanding Cash flow
Before we begin to understand the assets and liabilities from a personal point of view, we need to understand cash flow. It is essential to take control of your finance. That’s a simple equation. Let’s see how to calculate it. The formula of cash flow is as follows.
[Income – Expenses = Cash Flow]
Add all your incomes, e.g., salary, interest on your fixed deposits, incentives, bonuses, etc. to get the income figure. Likewise, add all your expenses, e.g., utility bills, EMIs, household expenses, commissions to your broker, etc. to get your expense figure. Then, subtract the expenses from your incomes. That’s your cash flow. You can calculate it on a quarterly or yearly basis.
How to interpret your cash flow?
If your cash flow is positive, then that’s good. But, if you have a negative number, then it’s high time to take action. Therefore, to make your negative cash flow to a positive one, you have to either increase your income or reduce your expenses. Sometimes, it is hard to increase your income. Thus, the other option left is to lower your costs. It may be a temporary solution to your problem, but try to increase your income in the long run.
All this is possible when you make a budget and track your income and expenses. But most people don’t care about it. That is a careless approach towards your finance and may create a dent.
What are assets and liabilities from a personal point of view?
Understanding assets and liabilities from a personal point of view are the basics of financial education. Let’s understand it in simple terms.
Assets are things that generate income for you. It makes you more productive. Thus, your bank deposits, investments in real estate, gold, stocks, mutual funds, are your assets. On the other hand, Liabilities are things that drain out money from your pocket. It makes you more miserable. Therefore, your bank loans, credit card bills, unpaid utility bills, taxes, mortgages, are your liabilities.
Assets Vs. Liabilities
Most often, we get confused between assets and liabilities. We think some of the liabilities as assets. That is a severe mistake, and therefore we pay a heavy price for it. That is to say; you must know who is your friend and who is foe. But, if you assume an enemy as a friend, then that can be fatal. To say frankly, most people think that they buy assets, but in reality, they buy liabilities. For instance, just raise your head from the screen and look around your house. How many of those things are making you productive? Are they putting money into your pocket or draining it out? Do they create value for you? Most of the answers will be a big ‘NO.’ They are pure liabilities.
Let me peep through your screen and count how many liabilities you possess. I can see many home appliances, electronic gadgets, furniture, car, and your beautiful home. If I am correct, all are liabilities. Because they never generate income for you. You buy your home appliances, insure them, maintain them, and throw them into your garbage room one day. Likewise, you buy your car, insure it, feed it with gas or diesel, maintain it, and visit a garage one day, and it never returns. Then, when did it make money for you? If I am correct, then it costs you millions.
Is your home an asset?
Your home can be an asset or a liability depending on its use. If you live in it with your family, then it is a liability. To clarify, you spend millions to buy it, pay local property taxes, maintain it, and repair it periodically. The maintenance cost only varies from 1 to 4% of the total value of your home. That turns out to be a considerable amount. After all, the average life of a house is 50-60 years. Therefore, it is a complete liability applying our cash flow theory.
However, it is a necessity. The other two are food and cloth. Therefore, you can plan to have one assuming you have positive cash flow even after your mortgage payments.
Liabilities are not liabilities.
The concepts of assets and liability are not absolute terms, but they are relative terms. To clarify, what is an asset for you may be a liability for me and vice-versa. For example, a car may be a liability for you, but not for an Uber driver. A car is also an asset for a businessman. A house may be a liability for a person living in it, whereas it is an asset for a retired person who lives on the rental income generated from it. A laptop or computer may be a liability for a person that doesn’t use it properly or play games. However, it is an asset for a YouTuber, a blogger, or a freelancer who creates a passive income. I hope you got my point.
Learning financial concepts can take you to the next level and create value for you. For example, once you understand the difference between an asset and a liability, you will hesitate to buy anything that will not create value for you. Thus, you can apply a simple formula to access the future value of a product or service. Just imagine if you need it after one month or not. If you think that you will need it even after one month, still leave that place. In most cases, you will realize that you were wrong at that movement.
That never means that you should not buy any liability in life. But your aim should be to minimize it. You can apply a simple formula to decide how much liability to buy. That is a maximum of 20% of your assets. In other words, if you have assets worth 100 million, then you can buy assets worth Rs 20 million. However, the opposite is true for most people.
To sum up, if a lot of liabilities surround you, convert them into assets. For example, if you have a car, then use it, occasionally try to rent it out to generate income. You can also rent a part of your house to others or tourists using Airbnb. There is nothing to feel shame. Moreover, you are creating value for you and the people around you.
I hope you enjoyed the lesson. The next step is to share it with your loved ones. You can do so by clicking the share buttons placed below. Your comments, suggestions are also vital for me. Therefore, don’t forget to comment.
Thanks and regards,