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Understanding the difference between assets and liabilities

April 16, 2024
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Finsesh
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Finsesh

Ensure you understand the foundation for getting wealthy.

Such an easy topic, yet it's the foundation for becoming wealthy. Ever wondered why the rich get richer and the poor, poorer? The rich truly understand the difference between assets and liabilities. Assets and liabilities is part of accounting, a subject taught in schools, but unfortunately most people never really understand the difference between these two at all, and even less on how to apply them in everyday life. This leads to the same old normal retirement plan which is risky to rely on at best, with only 6% of South Africans able to retire financially independent. 

Let's rekindle some of the love for basic accounting and apply the knowledge.


 

Benefits of understanding 

  • Once you understand the difference between assets and liabilities you will not only make money but understand the concept of retaining money and even pass it on for generations. 
  • You will be able to see asset-buying opportunities along your path to financial independence.
  • You will get clarity on your current lifestyle and review your assets and liabilities. 
  • Understanding the difference between assets and liabilities will provide you with the basic financial literacy to achieve your financial independence goals.

If you're thinking, yes I know what an asset is and what a liability is, then continue reading, if you're a little unsure as most people are then you definitely need to continue reading. 

As a rule, remember this: Assets provide income while liabilities create expenses. 

 

What are assets and liabilities?

 

Liabilities: I Googled what the internet thinks a liability is and it provided this definition a thing for which someone is responsible, especially an amount of money owed. This definition is partially correct and could be taken a step further. Liabilities are all expenses you have monthly not generating an income for you over and above basic needs. Liabilities are expenses. For example home mortgage, tax, clothing, entertainment, cars, boats etc. The only exception for having loads of liabilities is when other people, such as tenants, are paying for it.

Assets: Googling what an asset is and it gave me this result: an item of property owned by a person or company, regarded as having value and available to meet debts, commitments, or legacies. with an explanation that assets represent a value of ownership that can be converted into cash.

In school, they teach us about two types of assets: tangible and intangible. Tangible assets are assets that can be touched with your hands for example land, buildings, and cash. A few years ago I would place stocks and bonds in this category but everything is online these days. 

Intangible assets are assets you can't physically touch such as software, patents, royalties etc. 

With financial literacy, you will understand that there are also income-generating assets and non-income-generating assets. The one provides a store of value that can be sold when needed, and the other will provide you with a lifetime of financial freedom by generating income such as dividends and interest, rental income, and royalties. These income-generating assets are the secret to building wealth.

 

How most people live 

Most people study to get a job, and the job is their sole income. They use this income to provide for basic needs then to buy a car, a house and fund their whole lifestyle from this one source of income. Problem is that the more you use this one source of income, the more reliant you become on it. You work even harder for a promotion, get taxed more, and keep on fueling your consumerism-induced spending habits. With no control over your finances and where money flows, at the age of 40, the normal person worries about retirement and only then wants to make a serious effort to get their family on track for retirement. Hoping and praying that their employer pension fund will be enough for retirement. The reality is, it won't be. This is the middle-class trap. 

 

How the aspiring financial independent live 

Most millionaires are self-made so they will follow the same path initially, they study to get a job. They educate themselves on financial independence and how to achieve it. By having this knowledge they invest in income-generating assets while they have a job, knowing that it will provide them freedom from the middle-class trap. They understand how to use their assets to pay for liabilities. By mid-40s they will have the option to keep working and would have escaped the middle-class trap. They will not have to worry about retirement as they are already financially independent. 

To solidify this difference between assets and liabilities we will use a picture from one of the most influential books on financial freedom, Rich Dad Poor Dad by Robert Kiyosaki. 

 

 

Let's explain the picture from left to right

The poor: They don't have assets or liabilities as they use their salary income directly for expenses that are most basic needs

The middle class: The middle class will have the basic needs expenditures same as the poor, but due to higher income they also acquire liabilities such as non-income-generating bonds, loans, and credit cards, car loans etc. These further add to their expenses that are directly funded by their salary income. 

The rich: The rich also have liabilities but you will notice that they have much more assets than liabilities. These assets create an income for them alongside their job initially and at a point, they don't need their job anymore. At this point all their assets fund all their expenses. As income-generating assets grow in value and income, the excess income is used to buy more assets. This is the simple reason why the rich get richer and the poor poorer. It's all about your assets!

 

How to build your assets

Start with financial literacy: by reading books, doing courses, following us on social media, talking to people who live financially independent, and learning how they reached this point. For most it will always be a pipe dream but, most people can reach it if they have the necessary financial literacy. As you build on your financial literacy there are three ways to build passive income, either property, stock market investing or business income. Key to financial freedom is a person's ability to convert earned income into passive income. 


 

Life only happens once, give yourself no option but the dream. 

Onward to Financial Independence 

If you found this blog post helpful please follow us on Facebook and Twitter @finsesh for more tips on Financial independence.


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