Everyone knows what assets and liabilities are… right? Maybe not… at least not the way you should understand them. This confuses many people because most people generally understand that an asset is something of value such as a home or a car, and this is where many people get into trouble .
Someone may believe they are buying an asset, but is it an asset if it actually consumes money from your other income sources? Let’s take a look at a couple of definitions for “assets” and see which one makes more “smart money” sense.
The general definition of an asset would be the things that we own that we could sell for money. Some common examples of assets, under the general definition, would be:
- Houses or other real estate
- Autos or other vehicles
- Household appliances
- Electronics, TVs or computers
- Money in an account
- Clothing, shoes and jewelry
- Stocks, mutual funds and bonds
The reality is most of the things on that list are NOT assets at all. For example, most homes on a day-to-day basis consumes money (up-keep, taxes, heating, cooling, mortgage payments, etc.) generated from other sources. A home may consume several thousand dollars each year though you get no money back (at least not until you sell the home). And if you do sell it for a profit, you still have to live somewhere. Ever tried to sell a car or truck to recoup the money you invested in it? Yeah… right! The same goes for furniture, electronics, jewelry, etc.
I think a much better definition of an asset would be anything that can be owned by an individual that has a positive cash value. In other words, assets generate income or at the very least are worth more money than you put into them. What are examples of income generating assets?
- Investments (stocks, mutual funds and bonds)
- Real estate other than your home (rental properties and land)
- Antiques and collectibles (items that tend to increase in value)
- Royalties (copyrights and intellectual property)
- Small and home-based businesses
There are three classifications of assets: Current Assets, Fixed Assets, and Intangible Assets.
- Current Assets are assets with dollar amounts that continually change and can be converted into cash within a short amount of time. Examples of current assets are cash, and savings accounts.
- Fixed Assets are considered tangible property that can’t necessarily be converted into liquid cash immediately. Examples of fixed assets are computers, vehicles, and real estate.
- Intangible Assets are significant items that cannot be physically touched, but can be converted over to cash. Examples of intangible assets would be copyrights, patents, trademarks and other nonmaterial assets.
Liabilities are anything that is owed by an individual or business that must be repaid. Liabilities do not generate us money, but instead costs us money. Liabilities are debts that must be repaid (usually with interest), taxes, and repair bills. Based on this, you can easily see how a home can be just as much a liability than an asset.
There are two classifications of liabilities: Current Liabilities and Long-Term Liabilities.
- Current Liabilities are debts that usually must be repaid within 12 months. This debt usually is repaid through your current assets account. Some examples of current liabilities are personal loans, payday loans (ugh!), credit card balances and store credit accounts.
- Long-Term Liabilities are debts that usually can be repaid beyond a year’s time. Examples of long-term liabilities would be mortgages, , car loans and leases.
Now that I’ve made it clear what are considered assets and what are considered liabilities, it goes without saying that it is in your best interest to have many more assets than you do liabilities. This is generally how the wealthy become wealthy—they actively seek to acquire income generating assets and reduce liabilities. All successful entrepreneurs and investors try to make their money work for them instead of them working for money. And you can’t do that if you continually acquire liabilities.
What to Do
- Avoid taking on debt for the purchase of assets that depreciate in value. In other words, or truck is not how you gain income generating assets.
- If you do take on a debt (liability), try to get the best interest rate possible and do not carry a balance on your .
- Taking on debt is acceptable when used for the purchase of assets that appreciate in value. So it’s OK to finance that house even though it won’t generate you current income because, like I said, you have to live somewhere.
- Rather than financing, it’s better to save the money beforehand and skip the interest altogether. This way, as you are saving, you are earning the on your money until you have enough to make the full purchase.
- Rather than using your current assets account to finance your “toys” and vacations, let your income generating assets purchase them for you. For example, you may do particularly well with a stock purchase and may want to use your profits to reward yourself with a vacation. That’s far better than taking money out of your bank account or “financing” it with a credit card.
- Establish multiple sources of income generating assets. This will not only increase your overall income, but will act as a buffer if your primary income stream fails. This is called diversification and one of the reasons why you must find yourself a to invest in. Instead, most employees have “all their eggs in one basket.” This can be financially disastrous if you’re ever laid-off or terminated.
I hope this helps you make better decisions when it comes time to spend your money. Remember, there is a big difference in the way the wealthy spends versus how most people spend their money. And if you have a desire to win the money game, you’ll have to adopt the tactics of those that are successful at it.