Why you should know the difference between an asset and a liability (This is a big one)

Hey friends,

I am reading Rich Dad Poor dad book. I found out about the topic that you will be reading on the newsletter today on the book only. I never knew this thing before reading the book. I urge you to read it fully because not everyone knows it.

Rule#1: You must know the difference between an asset and a liability, and buy assets.

If you want to be rich, this is all you need to know. It is rule number one. This may sound absurdly simple, but most people have no idea how profound this rule is. Most people struggle financially because they do not know the difference between an asset and a liability. 

“Rich acquire assets. The poor and middle class acquire liabilities that they think are assets,” said rich dad. 

Rich dad said them that if you only understand this then you will become rich. It is that simple. One of them asked, “If it is so simple then how are not people rich?” 

Rich dad replied them, “ Because they do not know the difference between an asset and a liability.”

Robert remembers asking, “How could adults be so misguided? If it is that simple, if it is that important, why would everyone not want to find out?” 

Then later he started to understand why that was the case. 

“As an adult, I have difficulty explaining it to other adults. The simplicity of the idea escapes them because they had been educated differently. They were taught by other educated professionals, such as bankers, accountants, real estate agents and so forth. The difficulty comes in asking them to unlearn, or became children again.“

Rich dad believed in KISS principle. So kept it simple for us, and that our financial foundation strong. 

“So what causes the confusion? How could something so simple be so screwed up? Why would someone buy an asset that was really a liability? The answer is found in basic education.”

We focus on the word "literacy" and not "financial literacy.”

What defines something to be an asset or a liability are not words. In fact, if you really want to be confused, look up the words “asset” and "liability” in the dictionary. I know the definition may sound good to a trained accountant, but for the average person, it makes no sense. 

An asset puts money in my pocket.

A liability takes money out of my pocket.

To us young boys, rich dad said, "What defines an asset are not words but numbers. And if you can’t read the numbers, you can't tell an asset. “In accounting,” rich dad would say, “it's not the numbers, but what the numbers are telling you. It's just like words.

It’s not the words, but the story the words are telling you.” 

"If you want to be rich, you've got to read and understand numbers.” If I heard that once, I heard it a thousand times from my rich dad.

Here is how to tell the difference between an asset and a liability.

Most accountants and financial professionals do not agree with the definitions, but these simple drawings were the start of strong financial foundations for two young boys.

This is the Cash-Flow pattern of an Asset:

The top part of the diagram is an Income Statement, often called a ‘Profit-and-Loss Statement.’ It measures income and expenses: money in and money out. The lower part of the diagram is a ‘Balance Sheet. ’It’s called that because it's supposed to balance assets against labilities. Many financial novices do not know the relationship between the Income Statement and the Balance Sheet, and it is vital to understand that relationship.

This is the Cash-Flow pattern of a Liability:

Now that assets and liabilities have been defined through pictures, it may be easier to understand my definitions in words. An asset is something that puts money in my pocket whether you work or not. A liability is something that takes money out of my pocket. This is really all you need to know. 

If you want to be rich, simply spend your life buying or building assets. 

If you want to be poor or middle class, spend your life buying liabilities.

Illiteracy, both in words and numbers, is the foundation of financial struggle. If people are having difficulties financially, there is something that they don’t understand, either in words or numbers. 

The rich are rich because they are more literate in different areas than people who struggle financially. So, if you want to be rich and maintain your wealth, it’s important to be financially literate, in words as well as numbers.

The arrows in the diagrams represent the flow of cash, or “cash flow.” Numbers alone mean little just as words out of context mean little. It’s the story that counts. In financial reporting reading, numbers is looking for the plot, the story of where the cash is flowing. 

In 80 percent of most families, the financial story paints a picture of hard work to get ahead. 

 However, this effort is for naught because they spend their lives buying liabilities instead of assets.

This is the Cash-flow pattern of a Poor person:

This is the Cash-Flow pattern of a person in the Middle Class:

This is the Cash-Flow pattern of a rich person:

All of these diagrams are obviously oversimplified. Everyone has living expenses, then need for food, shelter and clothing. The diagrams show the flow of cash through a poor, middle class, and wealthy person’s life. It is the cashflow that tells the story of how a person handles his or her money. 

“The reason I started with the story of the richest man in America is to illustrate the flaw in believing that money will solve all problems. That is why I cringe whenever I hear people ask me how to get rich quicker, or where should they start. I often hear, “I’m in debt, so I need to make more money.” -A story for another day.

But more money will often not solve the problem. Infact, it may compound the problem. 

On a side note: This ‘Money will not solve problem’ is a very big topic. If you want to learn more about it, then click the link. It will take you to another newsletter where you you will learn why it is so. 

How a house is not an asset and how it is a liability. 

The diagram above illustrates the difference in perception between my rich dad and my poor dad when it came to their homes. One dad thought his house was an asset, and the other dad thought it was a liability. 

I remember when I drew the following diagram for my dad, showing him the direction of cash flow. I also showed the ancillary expenses that went along with owning the home. A bigger home meant bigger expenses, and the cash flow kept going out through the expense column.

Today, people still challenge me on the idea of a house not being an asset. I know that for many people, it is their dream as well as their largest investment. And owning your own home is better than nothing. I simply offer an alternate way of looking at this popular dogma. If my wife and I were to buy a bigger, flashier house, we realize it wouldn’t be an asset. It would be a liability since it would take money out of our pocket. 

So here is the argument I put forth. I really don't expect most people to agree with it because your home is an emotional thing and when it comes to money high emotions tend to lower financial intelligence. 

I know from personal experience that money has a way of making every decision emotional. 

I am not saying don’t buy a house. What I am saying is that you should understand the difference between an asset and a liability. 

I am not saying don’t buy a house. What I am saying is that you should understand the difference between an asset and a liability. 

When I want a bigger house, I first buy assets that will generate the cash flow to pay for the house.

My educated dad's personal financial statement best demonstrates the life of someone caught in the Rat Race. 

His expenses match his income, never allowing him enough left over to invest in assets. As a result, his liabilities are larger than his assets.  

The following diagram on the left shows my poor dad's income statement. It is worth a thousand words. It shows that his income and expenses are equal while his liabilities are larger than his assets. 

My rich dad's personal financial statement on the right reflects the results of a life dedicated to investing and minimizing liabilities.

Why the Rich Get Richer

A review of my rich dad's financial statement shows why the rich get richer. 

The asset column generates more income to cover expenses, with the balance reinvested into the asset column. The asset column continues to grow and, therefore, the income it produces grows with it. The result is that the rich get richer! 

Why the Rich Get Richer

Why the Middle Class Struggle

The middle class finds itself in a constant state of financial struggle.

Their primary income is through their salary. As their wages increase, so do their taxes. Their expenses tend increase in proportion to their salary increase: hence, the phrase "the Rat Race." They treat their home as their primary asset, instead investing of in income- producing assets.

Why the Middle Class Struggle

What you should do

As I said at the start of this section, the most important rule is to understand the difference between an asset and a liability. Once you understand the difference, concentrate your efforts on buying income-generating assets. 

 That’s the best way to get started on a path to becoming rich. Keep doing that, and your asset column will grow. 

Keep liabilities and expenses down so more money is available to continue pouring into the asset column. Soon the asset base will be so deep that you can afford to look at more speculative investments: investments that may have returns of 100 percent to infinity; $5,000 investments that are soon turned into $1 million or more, investments that the middle class calls “too risky.” 

The investment is not risky for the financially literate. 

If you Do what the masses do, you get the following picture:

So many people don’t take the time to question whether something makes sense and simply follow the masses. Often they mindless repeat what they have been told: "Diversify." “Your home is an asset.” Don’t. make mistakes.” “Don't take risks.”

Because of the large amount of time Robert and Mike spent in on meetings with rich dad and learning from the intelligent people he surrounded himself with, they learned a lot—and learned to question the standard dogma taught at their schools. It began to cause problems and made them grow distant from their teachers.

Robert also began disagreeing with his own father over money matters, especially when it came to his poor dad's view that his home was his greatest investment. In contrast, rich dad saw his home as a liability. 

Many people still believe that their home is an asset. But Robert teaches that home is a liability, because it takes money out of your pocket— not only with taxes and expenses, but because of its loss in value and the opportunities missed when all your money is tied up in your house. And that causes you to lose out on the education of investment experience. 

So what should you do?

That doesn't mean you can't ever buy a bigger house. But make sure to first buy assets that will generate the cash flow to pay for the house. 

When there are enough assets to generate more than enough income to cover expenses, the balance is reinvested into assets. Which grows the asset column on a balance sheet. Which produces more income. The result is that the rich who understand the difference between assets and liabilities, get richer.

The middle class get stuck in the Rat Race because they treat their home as an asset instead of investing in income-producing assets. They are also stuck because their salary is their primary source of income— and then when their income increases, so do their taxes. 

Many invest in mutual funds, paying a manager to handle their accounts because they don’t have the time and expertise to do it themselves. They feel like a mutual fund is playing it safe, and they have to play it safe because their balance sheet are not balanced. They can’t take advantage of opportunities because they are maxed out on debt and only have their salary bringing money in. 

Want to grow rich. Concentrate your efforts on buying income-producing assets—when you truly understand what an asset is. 

Keep liabilities and expenses low. You will  deepen your asset column. 

So how do you know when you're wealthy? One way of stating it: Wealth is the measure of the cash flow from the asset column compared with the expense column. When your assets generate enough income to cover your expenses, you are wealthy, even if you are not yet rich. 

If you want to know how to measure wealth click the link below. On that place I share how to measure wealth like Robert does.

If you want to learn another way of measuring wealth that I have learned then click the link below. This way of measuring wealth was used by the Richest man in Babylon. On that page I share how to measure wealth as shown in the book the The Richest Man In Babylon.