Monday, August 07, 2006

Difference between Asset and Liability

Before proceeding on our journey towards attaining personal freedom, I have to know whats my net worth.

Now what is net worth. Net worth, for a company is total assets minus total liabilities.

Cash flow refers to the amount of cash being received (positive cash flow) and spent (negative cash flow).

Assets?? Assets are anything owned by me which can produce future economic benefit (monetarily). We have many types of assets like current assets, investments, fixed assets, intangible assets and other kind of assets like good will. Keeping all these classification aside, an item which generates a positive cash flow, is an asset.

Liability are anything which we owe to others like loans, or like those activities which results in a negative cash flow.

Lets look at some examples to clear this concept. For instance, I bought a car for 4 lakhs (assume we have bought with full payment upfront). So to use that car, I need to pay for the petrol, for maintenance, for accessories. These are all negative cash flow. The only positive cash flow would be the amount you can save if you had communted by auto/taxi/public transport, which I am sure would be -ve. This is not a good deal, its a liability. If it gives me an intangible advantage in the business I am in, then its an asset.

So to say, I have bought a house with a monthly EMI of Rs 10,000 with a down payment of say Rs. 3,00,000. I am renting the house at Rs 8000 a month with a deposit of Rs 80,000 (10 x rent). So lets calculate the cash flow statement for a year (Assume a 4% interest rate)

Cash Flow per year
Positive

Interest received on 80,000 @ 4%=3200 (Taking only interest in calculation, since deposit has to be returned)
Rent received 8,000 x 12= 96000
Total=99200

Negative


EMI payable 10,000 x 12=120000
Interest lost on downpayment=12000
Total=132000

So Total cashflow is 99200 - 132000 = - 32800. We have a negative cashflow of 32800. This means the house which we have bought is not an asset but actually its a liability. (Keeping aside the tax benefits)

This example is to make the difference between asset and liability clear. People generally consider buying a house, car or a laptop as investment. Unless and until these articles generate a positive cash flow, its a liability.

Do leave a comment, if anything is not clear to you. I would be glad to help you.

Next Article: I will calculate my net worth and show you the need for calculating net worth. Stay with me in this journey. See you tomorrow.

3 comments:

rupee said...

A good read Track your spending.

Anonymous said...

Now consider a time frame (about 5yrs).
The rent will be used to cover your loan and after the loan has been paid off, you will ahve a greater income since the 80000 will be received on a monthly basis therefore renting that house will be quite a good asset.

기웅 said...

I've read a book, "RIch Dad Poor Dad". The book wants us to know a notion of difference between asset and liabillity. I may think that it requires us to understand and keep in mind the notion.

If buying some things, should appreciate plus and minus of them by using accounting calculation?