Assets Versus Liabilities: Knowing The Difference for Financial Success was written by Chris Alarcon and originally appeared on Wealth of Geeks. Chris is the driving force behind Financially Well Off – the ultimate destination for those looking to achieve financial independence, explore the world and stay motivated daily. If you're ready to transform your perspective on money and take charge of your life, you've come to the right place. It has been republished with permission. Please note that contributing opinions are those of the author. They are not always in strict alignment with my own opinions. –Joe.
Understanding assets and liabilities is pertinent to achieving financial success.
Assets, like real estate, appreciate and help you make extra money. On the other hand, liabilities do the opposite and drain your wallet.
Let's cover these in detail so you can avoid financial pitfalls.
Assets Versus Liabilities
Your accounts payable balance sheets will include all assets and all liabilities.
Although liabilities take money away from the investor, they're not all bad. Well-managed debts can help increase revenues.
Take a business with no website or office, for example. With proper financing, that business can take out short- or long-term loans to fund needed expenditures and be better positioned to increase its revenue.
Simply put, assets are beneficial. You want to invest in assets because they can have short- and long-term effects.
There are two different types of financial assets: current and fixed.
Current assets are short-term assets the investor typically plans to use within one year—for example, cash and bonds with a maturity date less than one year away.
On the other hand, fixed or long-term assets are used over a more extended period—for example, software, furniture, and vehicles.
Assets can further be classified based on liquidity, which means how quickly and easily an asset can be sold for cash. The two types of assets, while referring to their state of liquidity, are liquid and illiquid.
Examples of liquid assets are stocks and bonds. They can easily and quickly be sold at market price because they have an active market with ready buyers and sellers.
How long can it take to sell real estate? Weeks, months, or even years. Real estate is an example of an illiquid asset. They are a challenge to dispose of and turn into cash, with some even requiring the seller to lower their prices to attract buyers.
Similar to assets, liabilities can also last for the short and long term.
Fixed liabilities include mortgages and deferred taxes, for example—intangible, payable obligations that do not change.
Is a Car a Liability or an Asset?
Sometimes it can be difficult to discern if something is an asset or liability—or it can be both.
For example, if you lease a vehicle for your business, it is a liability because you did not purchase it. Payments toward this lease will not benefit the company, nor do you own the car.
However, if you intend to purchase this vehicle, it should be classified as a tangible asset and a liability on the balance sheet. Once the total amount of the car is paid off and you do not owe any more payments, the liability will be considered complete.
The Impact of Liabilities on Financial Success
Liabilities constantly take cash away from a business through payments, whether loan repayments or service/product delivery. If not well-managed, liabilities can cause a financial problem that can be hard for a business to recover.
When a business decides to take on liabilities, it's committing itself to make regular payments. What happens when the business fails to meet its obligations? It risks attracting consequences such as fines, penalties, and auctions.
But can liabilities be used to propel a business to success? Well, yes, it can.
Adding to the example given above under the section, assets vs. liabilities, here are more ways liabilities can be beneficial.
Financing an investment: Raising capital for growth purposes can be challenging for most businesses. Instead of selling its equity or diluting ownership of the business for capital, a business can choose to take on debts it can handle.
Expansion through leasing: There are certain liabilities, like company vehicles, that can be leased out as a way of raising funds for other important operations. By leasing a liability property or equipment, a business saves cash that could be used to operate the liability.
Assets, Liabilities, and Equity
Here is the basic accounting equation to determine your total assets:
Assets = liabilities + equity
So far, we've covered assets and liabilities, but what is equity? Consider equity as your total net worth after calculating your current assets minus liabilities. Ideally, the result of this accounting equation should be positive and high.
If you're running a business, odds are you're not a bookkeeping expert. However, you or your accountant should monitor your company's balance sheet and note if your total liabilities outpace your total assets over time.
Accounting software like QuickBooks is an excellent option for many business owners to keep track of assets, liabilities, and cash flow.
Using Assets To Build Wealth
Let's break these down.
If you're like me and don't enjoy spending hours each week analyzing which companies are the most profitable for their stockholders, index funds are a great place to start.
If you're investing through your employer, review their options and choose the ones with the lowest fees and the longest track record. Ultimately, making long-term investments in stocks will increase your accumulated assets over time.
If you need more clarification about investing, The Little Book of Common Sense Investing and The Bogleheads' Guide to Investing are great books to read.
It's no secret real estate has helped many build wealth. A problem most people face is needing more money for the initial down payment or to afford the mortgage.
If this is the case for you, focus on different ways of growing your net income, such as starting an online business or making a strategic career shift where you'll get paid more.
With enough income accrual, you can start saving enough to purchase a property with a 5%–20% mortgage down payment. You can either rent out your property, invest money in renovating it, and sell it later for a higher price.
Rental Property Investing by Brandon Turner is an excellent resource if you want to learn about investing in real estate.
It's hard to ignore how popular the internet has become over the past few decades. More and more businesses are being created online, and becoming a business owner is easier than ever.
The ability to start a business online means, as a business owner, you need to prepare to fail often and learn to increase your working capital.
Some business options include starting a blog, creating a clothing brand, or building websites for other businesses. You've likely seen articles online or read books about it but have yet to start a business.
The truth is it's more challenging than many make it seem. But with patience and hustle, you'll build an asset that keeps giving, putting you in a better financial position.
Many have transitioned to working online full-time; others use their side business to pay off debt incurred or invest aggressively toward retirement.
You're Now Ready To Reach Financial Success
One of the most essential parts of achieving financial success is understanding the difference between assets and liabilities.
To make sound financial decisions, we suggest you always do the following:
Evaluate your purchases: Ask yourself whether the purchase is an asset you will appreciate or a liability that will add more debt to you and if it is worth it.
Set financial goals: Always define your financial goals and set measurable goals. Now, your decisions should always align with your goals.
Consult professionals: Financial decisions and situations can be complex. Professionals have the expertise and experience to deal with different situations. You can get personalized investment guidance.
Hopefully, after reading this article, you feel more informed and confident in your knowledge.
Prioritize investing in assets and work on minimizing your liabilities. Doing so will improve your financial health and stress less over your finances.