Investing: Making Sense of Assets and Liabilities

There is a general misunderstanding about the actual meaning of Asset and Liability. To a lay person an asset is something you own like a house, car or machinery and a liability is something you owe to someone like a loan or tax etc.

However this is not true.

When you compare your assets and liability to calculate your net worth, you will realize that what you thought as an asset is in fact a liability to you. How this is possible is what we are going to find out and how we can be sure whether the assets you are holding are indeed true assets.

What are Assets and Liabilities?

Assets: As said earlier the exact meaning of an asset slightly varies from what we have learned so far. This is because what you think as an asset is not exactly an asset until it starts producing money for you on a regular basis and continues to do so in future.

Thus, your possessions like TV, Fridge, Car, Computer, and gadgets, even though you think as your assets, actually do not bring you any gain but only depreciates its value. In addition, it brings along other expenditures like repairs and maintenance. Hence, they are not in fact assets.

A diagram indicating how cash flows between assets and liabilities.

Your actual assets are those that brings in income to you such as income generated on bank accounts, investments, trading, inventories, rental properties, real estate etc.

An asset brings you positive cash flow; that is it brings in more money into your finances. If an asset is consuming lot of money in way of maintenance, repair, or other expenditures like loans etc., then it is not an asset but a liability to you.

Liability: On the contrary, a liability is something that makes you spend money. E.g. Loans, accounts payable, mortgages, deferred revenues, accrued expenses etc. This is negative cash flow and everything that causes a negative cash flow in your financial statement is a liability to you.

The difference between asset and liability at any given point of time decides the equity or the net worth of a person, company or organization.

An Example – Investing in a Rental Property

Now let us understand how an asset can sometimes become a liability to us without our realization. The following example will help you understand whether a property you bought recently is an asset to you or a liability.

Imagine that you bought a house for Rs. 40 lakhs. For the purchase you invested about Rs. 4 lakhs from your own pocket as down payment and for the rest of the amount you took a mortgage with an equated monthly installment of Rs.20000.

After buying the house you decided to rent the house for Rs.18000/- per month, with a rent advance of Rs.180000/- (18000*10) so that your EMI payment is taken care of from the rent received. As of now you are convinced that you have an asset with you. Let us now really understand whether this is so.

The following is the money coming to you or your positive cash flow:

Rent Received     18000*12 = 216000
Interest received on Rs.180000 @ 10% = 18000 (As Rs.180000/- is refundable; only the interest can be taken into account)

Therefore, Total (Positive Cash Flow) = 234000
The following is the money you are paying to the financier:

EMI payable 20000*12 = 240000
Interest lost on down payment @ 10% = 40000

Therefore, Total (Negative Cash Flow) = 280000
Now the total cash flow when calculated shows an overall negative cash flow of -46000.

This is a drain on your pocket and hence this house is not an asset to you but a liability to you until either your loans are completed or the market value of the property increases more than the purchase cost. (Please note this example is just an illustration ; real life examples may be different).

Once you understand whether you are holding more of assets or liabilities, you can balance your financial status by increasing your investments in other profitable areas.

Thus if you are planning to make any investments in the future please make sure that you invest in more and more assets than liabilities so that you can make your money work for you.

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