An asset is a resource owned with the expectation it will provide a financial benefit. It may produce income, increase in value over time or reduce expenses.
These are assets expected to increase in value, over and above the costs involved holding them.
They may not produce a physical (taxable) income in the first few years.
Investment in appreciating assets can come with significant long term financial rewards. But asset selection and a long time frame is critical to actually make a profit.
Capital growth property is higher risk because it generally involves significant leverage (debt). There may only be a small contribution of your own money, but you can lose far more if you select the wrong asset.
Often, you are contributing money on a monthly basis to hold this sort of asset, although this can be softened with the tax benefit of negative gearing.
You need to be an expert or hire a (carefully chosen, trustworthy) expert to invest capital growth property.
Shares / ETFs can also be appreciating assets, if the companies involved are expected to increase in value. With individual shares, again you need to be an expert or hire one to succeed. Even then, research tells us even the experts don’t get it right consistently.
Broad ETFs (such as ASX 300) are expected to increase in value over the long term. As long as you buy broad, hold long term, and don’t panic and sell during a market dip/crash this is an easy strategy. If you add leverage to this investment to expedite returns, risk increases significantly.
A lot of investors feel more comfortable with income assets. Because they provide a cash return from day 1 they feel this is a less speculative/ risky approach. The returns are taxed, and tend to be inferior to capital growth that can compound for years untaxed.
These assets can, of course, still lose significant value, but income investors fret about this less as long as the income keeps coming.
Examples of income assets would be positively geared property and dividend focussed ETFs or shares.
Expense Reducing Assets
We often don’t consider expense reducing assets, but your home is one (in preventing the need to pay rent).
Solar panels reduce your ongoing electricity bills for the next decade or more (as long as you stay put). Whether they provide sufficient return on investment along the with environmental benefits is up to you.
What assets reduce your ongoing expenses?
Many people consider anything with monetary value an asset.
Your car is worth some money, and could be sold to liquidate the cash if needed. But the value of 99% of cars depreciates over time. And you may not be able to get to work without a car.
On top of that, ownership of the car actually produces extra expenses, such as tax and insurance. For that reason, most with an interest in personal finance would consider depreciating assets like cars a liability.
Boats, caravans, motorbikes and jet skis are also depreciating assets (aka liabilities). These are a lifestyle choice, but are doing nothing positive for your finances.
You can consider your home an asset under some, but not all circumstances. It does not create an income, but does reduce expenses by way of saving rent. But you are still “wasting money” on interest for the honour of home ownership.
In order to consider a principal place of residence (PPOR) an asset, the following equation applies.
Renting is likely to get more expensive over time, so the equation becomes more favourable the longer you stay. It is also far more likely to be in favour of owning if you want to live in an area with good capital growth potential.
Buying in an area with low capital growth expectation for under 10 years may seem better than renting, but remember to consider opportunity cost. Would you better off renting and buying an investment property in a better area?
The Balance Sheet
A balance sheet is a snapshot of a business, demonstrating it’s assets and liabilities at a particular point in time.
Successful money managers treat their personal finances more like a business, ensuring long-term financial growth and sustainability.
Monitoring your own “balance sheet” allows you to track your progress over time – and appreciate progress made.
Applying these concepts to personal finances will also help us understand investing opportunities better.
Assets are listed according to their liquidity. That is the ease of getting money out at short notice in case it is needed.
Current Assets (Can be converted to Cash within a year)
Cash & Cash Equivalents – This is your emergency fund, savings accounts, offsets
Marketable Securities – Any ETFs, shares or other liquid investments
Accounts Receivable – Money that you are owed and are expecting to recieve. Expected tax refunds and owed income goes here.
Pre-paid expenses – If you have paid your investment interest a year in advance
Long Term Investments – cannot be liquidated within a year
Fixed Assets = Property & Land
Intangible Assets – These are “assets” that increase earning potential and are difficult to put a value on for the individual.
I still think it’s worth reflecting on what intangible assets we have, or could acquire.
For me these include a medical degree, specialist qualification, professional reputation and finance/investing knowledge.
Are what you owe to others. Again they are listed as current (within 1 year) and long-term.
Current Liabilities includes credit cards payable, tax bills pending, this year’s mortgage repayments, investment debt interest and student loan payments.
Long term Liabilities. For me this is bank loans on my PPOR and investment properties. You may have other debts expected to take more than a year to pay back – student loans, car repayments etc.
Share Holders’ Equity / Net Worth
OK you probably don’t have shareholders as an individual or household!
On a business balance sheet the calculation is often stated as
Which is a different way of saying
Your equity / net worth should increase overtime. This may involve increasing purely assets (eg direct debiting into ETFs) or increasing your liabilities (debt) and assets by purchasing growing assets. It could also be achieved by simply reducing your liabilities. All three may be appropriate at different stages of your life.
Debt to Equity Ratio
From the balance sheet the debt/equity ratio can be calculated.
Debt/Equity ratio = Total Liabilities / Total Assets
This may increase at times, particularly when starting investing in property. Banks, when assessing loan risk don’t take into account your current assets e.g. Cash in an offset, but only Loan/Property value.
Investors will often borrow up to 80% of this ratio. Those in an ultra low risk of default occupation may be offered loans of up to 90% LVR (loan: Value ratio) without the need for lenders mortgage insurance.
In reality though your true debt / equity ratio may be a lot lower due to a generous cash emergency fund stored in your offset account. This may be the more useful ratio to monitor for your own information.
Acid Test Ratio
The Acid-test ratio looks at the ability of a company to cover it’s short term liabilities with it’s current assets. As a household, this ensures you can cover all the bills for the next year – pretty important!
Acid test = Current Assets/ Current Liabilities
If you are looking to build wealth, you will want to start building an asset portfolio. Make sure you are buying assets, not sneaky liabilities!
To see all the wealth building strategies shared with Aussie doc freedom, check out the Ultimate Step by Step guide to Wealth building, with wealth building strategies.
Aussie Doc Freedom is not a financial adviser and does need offer any advise. Information on this website is purely a description of my experiences and learning. Please check with your independent financial adviser or accountant before making any changes.