A key to your financial success is having a sound understanding about money and basic finance. Investing in your financial education is one of the best first steps towards your goal of financial independence and freedom from work — being able to quit that job you’re so sick of.
To quote Robert Kiyosaki:
We were not taught financial literacy in school. It takes a lot of work and time to change your thinking and to become financially literate.
Financial literacy is so important I thought it would be worthwhile to continue on from my previous article and write Part 2.
A quick recap. In Part 1 I explained that one of the main reasons people are poor is because they only have one source of income / cash flowing in whilst they have ten, fifty, a hundred sources of expenses / cash flowing out.
In this part I will highlight another big reason I’ve observed and that’s not comprehending the fundamental differences between an asset and a liability.
What’s the difference between and asset and a liability?
Here is the formal definition of an asset from the International Accounting Standards Board (IASB) Framework:
An asset is a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity.
Here is the definition of a liability:
A liability is a present obligation of an entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
Confused yet? I don’t blame you. While the above definitions may be technically correct and useful to accountants, it’s not as helpful for the average person.
This is why I like Robert Kiyosaki’s take on this. In his classic book Rich Dad Poor Dad he puts it so simply:
Assets put money your pockets. Liabilities take money from your pockets.
I like this definition as its emphasis is on cash flow. An asset is something that puts cash flow into your pocket regularly whereas a liability sucks cash flow out of you.
Some examples using this simple framework.
If you own an investment property and each month it generates rental income for you then it’s an asset. If you own shares and you receive regular dividends then it’s an asset. If you have a business or a side hustle on the side then again that’s an asset.
Conversely, think about what sucks out cash flow from you. If you buy that new Tesla and finance it subject to interest and monthly repayments then that’s a liability. Based on this cars are big time liabilities. Besides the monthly repayments they also suck cash flow in the form of insurance premiums, vehicle registration, taxes, maintenance and gas.
Those are just a few examples but I hope with this simple framework it will get you thinking and apply it to your personal circumstances. The next time you buy something ask yourself whether it is an asset or a liability.
The reason why you’re poor…
Is because you buy too many liabilities and not enough assets if any at all.
At its simplest, the rich become rich because they spend their lives accumulating assets which generate cash flow for them which serve to proxy for their time so that they don’t have to keep exchanging time for money. With this freed up time they can then focus on accumulating even more assets in resulting in an upward cycle.
On the other hand the poor become poorer because they spend their lives accumulating liabilities and other doodads. They sell their time for money in the form of jobs and employment and use their hard earned money on things that have no value or suck their cash flow.
So the poor lack money, but they also lack time. This is due to the vicious downward cycle of constantly being busy and lacking time because you’ve sold all your time for money. I call this vicious cycle Time-Money-Servitude.
Knowing this, will you think twice before going on your next shopping spree?
I will just add for your awareness that Robert’s definitions aren’t without controversy. Like with anything, there were those (mainly accountants) who criticized him for overly simplifying a relatively complicated subject like accounting.
To summarize it for you, the main criticisms were around the following points:
- Cash flow shouldn’t be the key determinant of whether something is an asset or liability. For example, strictly speaking an asset is just anything of value or that retains value. So if you decided to sell your car tomorrow you would still get something for it.
- Robert controversially applied this definition framework to your family home (“your house is not an asset,” he declared) which caused quite a stir. Since it only takes cash out of your pocket each month (mortgage repayments) he counted it as a liability. Accountants were quick to point out that this is ludicrous — if you sold your house tomorrow you would surely get something for it. In fact most accountants claim that your house is your biggest asset.
- Gold, jewellery, antiques, art pieces and other collectors’ items don’t generate any cash flow and in fact often have storage costs associated with them so based on Robert’s definition these would be liabilities. However if these were to be sold they often fetch good prices.
Overall I think that despite the criticism there is merit to Robert’s framework. There may be times it leads to a technically incorrect classification of asset / liability but it’s a simple and useful framework for you to have in your mind the next time you are about to buy something.
What do you think of Robert’s definition of asset and liability? Do you think it’s accurate / helpful? I would love to hear your thoughts on this.