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You plan a tower that will pierce the clouds? Lay first the foundation

Recap:Swayam was now king of the world. All the hours of studying in school, college had paid off, he had the job and he would spend  money  living life king size. But then he was pulled in different directions-taxes, savings, insurance,  investments,  stocks, mutual funds, . He realized he was educated but had no financial education and started on money awareness journey. He brushed up his school maths  such as percentages, compound interest.  He also learnt that It’s not what you earn that makes your financial position! Today he will learn about the four cornerstones of one’s financial position:Income, Expenses, Assets and Liabilities. Note these terms can be applied to companies and individuals but here we will focus on individual.


Foundation of a building is the structure below the building and one pays the least attention to. It sits quietly below anchoring the building to the ground. Without a sound foundation, the building could literally sink to the ground or blown away. Similarly the four corner stones of your financial foundation are as follows:
1. Income : Is what one earns.  Technically it can be defined as the money or its equivalent received during a period of time in exchange for labor or services, from the sale of goods or property, or as profit from financial investments.
2. Expenses : is what one spends. Most of us spend money on food, clothing, house, mobile, utilities, entertainment, etc. Each month we get bills for our expenses and use money from our income to pay for them. An expense or expenditure is what one pays to another person or group for an item or service. For a tenant, rent is an expense. For students or parents, tuition is an expense.

3. Assets : adds to one’s income now or in future strengthening  one’s  financial position ex: investments in gold/silver, deposits, stocks, mutual funds, art/antiques, land or house.  Asset is something that generates money for you. If you have to work to generate money, then that is Income. If you do not have to work but keep getting money, then that source of Income is your Asset. Robert Kiyoski  in  Rich Dad, Poor Dad series defines Asset as one that puts money in your pocket. Assets are the things that we own that we could sell for money. Some common examples of assets are:

  • A house or other real estate
  • A car
  • Household appliances
  • Electronics like a TV or computer
  • Our furniture
  • Money in a bank account
  • Clothing, shoes, etc
  • Stocks, mutual funds, bonds, etc
Some assets can be sold for more than we paid for them and some can only be sold for much less than we paid for them. When an asset goes up in value it is said to have appreciated. When an asset goes down in value it is said to have depreciated. For example, a house tends to have a very stable value and will usually slowly appreciate (go up in value). On the other hand, a computer depreciates (goes down in value) very quickly so that after a couple of years it can only be sold for a fraction of what we paid for it.

4. Liabilities:is a form of obligation or responsibility. It represents an outstanding debt, products or services that have yet to be provided, or acknowledgment of responsibility and payment provided for damage caused through actions or negligence. Robert Kiyoski  in  Rich Dad, Poor Dad series defines Liability as one that takes money from your pocket.  It weakens one’s financial position. Ex:

  • An old vehicle that needs a lot of fuel and repairs,
  • Personal loans,
  • Credit cards,
  • Education Loan
  • Home loan or mortgage,
  • Payment plans for purchased items purchases or commitments that we take and service for long period of time.
Debt usually has an interest charge associated with it. So the amount that you need to pay back is the total amount that you borrowed plus any interest charges. For example,
If you borrow Rs 100 at an annual interest rate of 9%, then
  • After one year you would owe109 rupees (i.e. 100+100 x .09).
  • At the end of the second year you would owe118.81 (i.e. 109+109 x .09).
So over time a liability (debt) will increase or, in other words, we will have to pay back more than one borrowed to get rid of a liability. It is important not to disregard the interest rate you pay on a liability because interest charges can add up to significant amounts over time. For example if one takes a home loan a large amount(sometimes more than the loan) is paid in interest as shown in the picture below.
Home Loan

Is House an Asset?

Just like assets, there are also good liabilities and bad liabilities:
  • Good liabilities gives one leverage — e.g., home mortgage, student loans, business loans, etc.
  • Bad liabilities put one at a disadvantage — e.g., consumer loans, credit cards debt, etc.

Liabilities can also be a significant source of expenses. Interest payments on loans and credit card debt can add up very quickly and really eat into our income over time. Then why do people own a liability? Because they think it will help them to build an asset such as home loan or  mortgage. But good liabilities can turn bad. For example, a mortgage that is too large. As mentioned in earlier article,It’s not what you earn that makes your financial position MD is about to loose his job and he has home loan of 52 lakhs to pay along with regular expenses including children education , 1 lakh per month. He has some savings in Mutual Funds and insurance policy but..!

Practical example of Asset and Liability

 

President of USA, Barrack Obama and his wife Michelle graduated with significant student loan debt.  “We left school with a mountain of debt,” Mr. Obama said in 2008. “Michelle I know had at least $60,000. I had at least $60,000.( New York Times).  Michelle Obama told women that when she and her husband left law school, the monthly payments on their school loan debt was more than their monthly mortgage payment, and that they only got out of that debt when Barack Obama wrote his two best selling books. To know more about click Obamas Financial Struggle

Net WorthThe amount by which assets exceed liabilities. This is one’s true wealth or net worth.  It can be a useful tool to measure one’s financial progress from year to year.

Net worth = Total assets – Total liabilities

The value in calculating Net Worth is to map out assets and liabilities  to gain actionable financial insights. For example, if after mapping out one’s  assets and liabilities, one realizes that one is up to Rs 20,000 in a savings account and has Rs 10,000 in credit card debt that one is paying 30% interest on, that can be an incredibly valuable insight to take action on.

Recap

Four Corner Stones of Financial Position

To find out how much rich a person actually is one uses Net Worth. For example as per gulfnews.com

 Mukesh Ambani remains the richest Indian on earth although his net worth has dropped by $4.4 billion (Dh16.16 billion) in the past year.

Savitri Jindal with net worth of $9.5 billion is ranked overall fifth in the list of 100 richest Indians and has become the richest woman of India.

richest.org  website lists richest people in various categories – Sports, Hollywood. For example as per richest.org, Mark Zuckerberg’s, founder of Facebook, net worth is $17.5 billion (as on Sept 2011)  and Aishwarya Rai Bachchan’s net worth is $35 million. Interested ones can read about Richest people of World and Rich people of  India at bemoneyaware.com

assets and liabilities

In Accounting Assets are on Left and Liabilities on the right side

Building wealth is a simple matter of increasing your Builders (Income and Assets) and decreasing your Bleeders (Expenses and Liabilities) or increasing your Net Worth . This sounds simple, however, it takes a lot of discipline and effort to build wealth. Sadly we do not allow people to drive a vehicle without taking a license test but allow them to enter complex financial world without much financial education. If you build a strong foundation your tower can reach the sky!

What else makes one’s financial position? How can one have a strong financial position? Do you think house is an asset or a Liability?

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