Getting it Right: Assets and Liabilities

Last Saturday, a network marketer showed me a video. 

I have a couple of network marketers trying to convert me: Trevo works, Swiss-Garde is different, NG4L is amazing, come aboard Forever Living Products. But I have a trouble selling products I won't buy. The only reason I will buy a Ginseng flavoured Multivitamin pack of 100 capsules for N2,000 is if it comes with a N1,500 MTN recharge card.

Back to the video. The guy in the video was talking about the low income class, the middle class and the rich. He said we in the low income and middle class are spending our money on liabilities while the rich spend their money on assets. Then he went on to give the strangest definition of assets and liabilities that I've heard. He said, "Liabilities are those things that cost you money. Like your car, your house, the stuffs occupying all the space in your rooms. And that's what the low income and middle income class spend all their money on. While Assets are those things that make you money. And that's what the rich spend money on."

On the surface you might consider him right. The poor spend all their money on things that don't make them richer and the rich spend their money on things that make them richer. That's what he was trying to say. And he would have been faultless if he had just left assets and liabilities out of his statements. Assets don't make you money and liabilities don't cost you money. Surprised? I'll explain.

Assets are what you own. Just as a company's assets consist of it's buildings, fleet of cars, all the goods in its warehouse, equipment and it's factories. They cost the company a lot of money. They are the company's assets, not liabilities. So all you own: your cars, your house, your clothes and every other thing you could sell, even for 1 naira, are your assets.

Then liabilities are what you owe. The money you borrowed from a friend is a liability. The business loan you took is a liability, even though it will make you more money. 

Here's the part most people don't know. Nothing in itself is an asset or a liability, it depends on whether you own it or leased/borrowed it. Money is an asset if it's in form of your salary; you own it. But a liability, if you borrowed it. A house is both an asset and a liability if you bought it via a mortgage (the explanation is a little complex, it's called a Capital Lease). 

How does this relate to being rich and being poor? If your assets exceed your liabilities by about a billion naira, then you're rich. In business, it's called Owners' Equity. Equity = Assets -- Liabilities. And that's how people's net-worth are determined. You put a naira value on all Mr B owns and you deduct all what Mr B owes from it. What you are left with is what Mr B is worth. 

How can you increase your net-worth with the knowledge of assets and liabilities? I don't know. The knowledge only explains what is happening, it can't make anything happen. The only thing you can do is to ensure your liabilities do not exceed your assets. But it's common sense. Every sensible person knows that he's not supposed to borrow more than he can afford to pay. 

But there's the more complicated and potentially rewarding part. It's partially built on a sound knowledge of assets and liabilities, but requires knowledge of a lot of other financial theories. The concept is that you can temporarily increase your liabilities well above your assets, and if done right, you'll end up extremely well off for it. It's called leveraging. It requires a good knowledge of business returns. You should be getting a return that exceeds the cost of borrowing (the leverage), and ensure your loan is not called unexpectedly.

In my series on NSE, I'll go in-depth while explaining how to read a company's balance sheet.