Assets and liabilities
Reading time: 8-11 minutes (2.079 words)
It is crucial to understand how assets and liabilities work in your journey to financial independence. Robert Kiyosaki defined these concepts in his book Rich dad, Poor dad (must read!).
- An asset is something that puts money in your pocket
- A liability is something that takes money out your pocket
An asset generates an income without you having to work for it. A job creates an income but is not considered an asset. You're simply exchanging free time for money.
An asset is the machine I talked about in the first chapter. The machine generates money without doing anything. How much money the machine makes depends on how much money, or in case of a business free time, you put in.
Which of the following are or can be assets:
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One time expenditures are not considered liabilities. For example, when you buy clothes or go to a restaurant. Although it takes money out of your pocket, it’s a one time expenditure.
Which of the following are or can be liabilities:
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99% of all people only focus on liabilities
The most important thing you learned in the previous chapter is that the economy only drives on one thing: spending money. If people stop spending money, the economy stops. There is a reason you won’t learn much about the economy, how to become wealthy or how to manage your personal finances in school. Because they don’t want you to know, they want you to spend. Why would 99% of the people focus on liabilities and getting a job if they know they can make way more money if they just focus on creating assets?
They only teach you one thing in school: working for somebody else. Working for somebody else is actually the least efficient way to make money. You’ll learn more about this in the next chapters.
There are many ways to make money. There are four main types of people making money in the market:
- The employee
- Self employed / freelancer(self employed without personnel)
- The business owner (self-employed with staff)
- The investor
The employee works for someone else to generate their income. Most people (99%) will fall into this group. Whether you work part-time at the supermarket or are a manager at a large company, you always depend on your job to receive an income and pay your bills. The following picture shows the income and expenditure pattern (assets and liabilities) of the employee:
The only asset an employee has in general is a savings account. But in the last few years, this would not even be considered an asset anymore because of the extremely low interest rates on your savings account. But in 2022, market interest rates are going up and sooner or later the interest you get on the money you have in your savings account will follow. Employees sometimes have another asset in the form of pension (depending on the country you live in). But they can’t touch it and have zero control over the outcome. Employees pay taxes before they receive their income.
The self employed
There is not much difference in expenditures between an employee or being self-employed. The self employed earn more money in general and sometimes have tax benefits depending on the country they live in. But they have no pension and insurance so they must take care of that themself. Assets and liabilities wise, the self employed have the same expenditures and liabilities. The self-employed pay taxes before they receive their income (most of the time).
The business owner
Now things are getting interesting. Where employees and most self-employed have to pay taxes before they receive their paycheck, business owners pay taxes after they deducted their expenditures. And this has a huge impact on how much taxes they need to pay. They can earn millions but pay zero taxes that way. The only difference is, they make those earnings not by earning money in the form of dollars or euros but spend this money to increase their asset (expand their business).
In other words, they make hundreds or thousand times more money than employees but pay less or sometimes zero taxes because they can deduct their expenditures from their income. Business owners receive a lot of tax benefits from the government. That might not look fair but the business owner does not only generate jobs for employees, they also take the risk of failing. Not every business is here to stay. You can’t build a business without taking risks. To compensate for the risks, business owners get tax benefits. But some companies take it to the extreme and are trying to find a way to avoid paying taxes all together. Like setting up fake companies abroad or setting up the business structure in a way they only pay taxes in very low taxed countries.
The reason why Amazon grew to a very big company in a relatively small time frame is because they paid almost zero taxes. They spend all their earnings in expanding the company. Amazon could deduct all their expenditures making it look like they hardly made any money on paper. Actually any company can do this, big or small. In some countries, a self-employed person can have the same tax benefits as a business.
This way they compound their returns. First they don’t have to pay taxes and they can spend all their earnings in expanding the business. That does not mean that the invested earnings in expanding the business will always make more money in the long term.
Business owners pay their liabilities with assets instead of an income generated by working for someone else:
The investor uses money to create more money. Every dollar in the bank account is a potential "wage slave" to make more money with. The investor has a great focus on creating assets. Their income looks like this:
To be clear, everyone has liabilities. It doesn't matter whether you are an investor, a business owner, self-employed or an employee. The essential difference is that for an employee and self-employed person their salary pays the liabilities and with an investor or business owner the assets pay for the liabilities.
Also, nobody starts as a full time investor. Simply because you need money to invest. Most business owners were employees before and slowly started their own business and became an investor along the way. You can also be an employee, business owner and investor at the same time in theory.
The business owner and investor always look for new ways to build new assets. Where the employee and self-employed only focus on exchanging free time for money. Exchanging free time for money is by far the least efficient way to make money. More on that in a later chapter.
The weight of liabilities
The vast majority of people strive for a steady job with a steady income making them think they are “safe”. But are they really? If you live a life with a focus on liabilities, your entire world collapses when you lose your job for whatever reason. Steady jobs are not safe at all. You are totally dependent on that one job and have to work till you can retire in your seventies.
People tend to live based on their income. As their income increases, so do their expenditures and liabilities. The problem is that most people can’t handle money. They spend all their money only to find out in their old days they don’t have any money left. They are 100% dependent on their pension, their own commitment to save money through their lifetime or the government.
Assets on the other hand can generate money basically forever. Some assets require your attention, others run on autopilot. Even long after you are retired. Even your kids (if you have any) can profit from these assets long after you’re gone. The more money generating machines you owe, the more money you can generate. If you look at any wealthy person in the world you’ll notice that they all have one thing in common:
Or they inherited assets from someone else. The only exception would be someone winning millions in the lottery. The most earning athletes don’t earn money from performing in their sports but selling their name on clothing, products, commercials, etc. They are the asset.
But even the most wealthy people in the world can’t outrun the weight of liabilities. Someone who is making $5 million a year can’t spend $10 million a year on the things he or she wants. Most wealthy people become wealthy because they control their expenditures.
It does not matter if you earn $1,500 or $100,000 a month. That's why you should never look at what someone else has. Driving a luxury car does not mean that person is rich. Maybe he took credit to buy the car. Maybe your neighbour bought that new car in cash because he earns three times more than you do. People tend to think that people living in the same neighbourhoods or driving a certain type of car earn a certain amount of money. That’s a total misconception.
The real reason why the rich only get richer
Have you ever wondered why 99% of all the money in the world is owned by 1% of the people? Well now you know. If 99% of the people only focus on liabilities and only 1% focuses on creating assets, where would all the money end up?
It’s no wonder that 99% of all the money in the world is in the hands of the 1%. It has nothing to do with unfairness or whatever. 99% of the people spend all their money on the assets the 1% created. In other words, your liabilities are someone else’s asset.
Just think about it. Who earns millions in the following cases, you or the company behind the product / service?
- Insurance of any kind makes the insurance company rich
- The mortgage you have on your house makes your bank rich (unless you rent out the property, then you both benefit)
- Your phone subscription makes your phone company rich
- Your car makes the oil companies, your go to garage and many other parties in between rich
- Your TV and internet subscription makes your internet provider rich
- Any product you buy (assuming it's a good product) makes the company behind the product rich
- Your subscription to the gym makes the gym rich (and hopefully you healthy)
And people don’t even realise it. Instead they think it’s unfair that so few people have so much money. That’s simply because people don’t understand how money flows. And it’s obvious that people don’t know this because they don’t teach you this at school.
Even if we divided all money equally, 99% of the money would inevitably end up in the exact same pockets. Simple fact is, 99% of the people have no clue how to handle money. Even the government knows this. That's why you have to pay taxes before you receive your paycheck and not after. If you received your loan including taxes, people would spend this money on liabilities or other things they don’t need and would be unable to pay taxes at the end of the year.
And for that exact same reason pension funds exist. People have no clue how to invest money or generate more money with money. So they force people to pay monthly contributions to a pension fund. Now this is not a bad thing but just to remind you they keep you financially stupid. You can outperform any pension fund if you started investing when you were eighteen till you're retirement age of seventy. Let’s imagine you invest $500 each month till you reach seventy (starting from eighteen) and assume you receive 7% gain on your investment (the average return in the last fifty years is about 7-8%). You would get almost 3 millions dollars! Or $120,000 each year till you turn 95. What pension fund will net you $120,000 each year? The only thing you need to do is to make sure you save $500 each month.
Again, a pension fund is a pretty good system overall but just because people have never learned how to efficiently make money. The reality is, if you want to become part of the 1% you need to create assets.
Chapters: How to become Financially Independent
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