Hey folks Dr Ro here.
A liability is an outstanding debt that you carry. So that could be a loan, a mortgage, for example, you may have money on a credit card that would be a liability as well.
The liabilities are what we owe other people, assets essentially are things that we own that have some value in them that if you were to sell them you can liquidate that cash.
So, for example, if you owned a house and that property was unencumbered with no mortgage on it then the full value of that property would be the asset.
So let’s say £150,000 property and zero mortgage on the property, then you’re looking at £150,000 worth of value in the asset.
If it had a mortgage of say £100,000 then your actual net asset value of that property would be £150,000 value minus £100,000 mortgage, leaving you with £50,000.
That would be the equity in the house. If you’ve got gold stored away somewhere and the value of that gold is £12,000 that would be another asset you might have in your name. You may have stocks in the stock market, you may have shares in a particular stock, and the value of those shares might be £2450, dollars, euros, that will be the asset value of that particular wealth vehicle. So what we’re doing is we’re adding up all of our assets and liabilities, and if you want to really do this properly then strip through everything that you physically own and then did you buy it for cash or did you buy it on borrowing.
If borrowing , how much is that borrowing?
If you’ve got a car and it’s worth £27,550 and you’ve borrowed £20,550 to buy it, that means £7,000 of your money is in it, the rest is borrowed from the bank so that would be a separation of the assets and liabilities.
The basic way to do this is split a line down the middle of a paper and on one side you title it assets and on the other side you put liabilities and list all your liabilities on one side and what you owe and that comes to a total. On the other side you’ve got your assets and that comes to a total. Hopefully if you’ve done it right your assets will be greater than your liabilities, which means your liquid in the sense that you have a value of a positive net worth.
Let’s say your total value of your assets comes to one million and the total value of your liabilities comes to 800,000, then you have a net worth on paper there of 200,000. There are other factors that come into this but that’s a simple way to look at it. This is different from income and expenses.
Income and expenses is your ability to look at what’s going in and out on a monthly basis.
That’s what’s keeping you afloat.
Assets and liabilities aren’t things that specifically are affecting your day-to-day living costs or your running costs, all of those things your lifestyle isn’t directly affected by your assets and liabilities. So in simple terms, you may have £1 million worth of assets, you might have £800,000 worth of the liabilities you may have, for the sake of argument, £6,000 a month going out to support those liabilities.
Your outgoing expenses could be what it costs you to eat, travel, to put a roof over your head on a monthly basis for example, and then utility bills et cetera. Let’s say that costs you £3000 a month, you might then have another £3000 a month in monthly payments on those liabilities.
Once this works it all comes into play and everything integrates together you have your loan over here to support all those loans could be five loans it’s costing you for the sake of argument, £3000 a month. Another lifestyle costs £3000 a month that gives you a total of £6,000 going out a month, of which £3000 is to support your loans to liabilities. You then have £8000 a month coming in from your income over here, so in that case you have what’s called a residual cash flow at the end of the month of £2000. £8000 in and £6000 out.
Now if you were to reduce your liabilities it means you owe less money to people. So if you cleared off all those liabilities effectively your outgoing expenses now are reduced down to zero on your expenses for your liabilities. If you were to clear down the liabilities all of a sudden, your monthly outgoing costs for those liabilities goes down so that means you are now left with £3000 month going out, so this is where the exercise comes into play.
Look at what your liabilities are, what your assets are, what your income and expenses are and then you start to play a game between all of those to find how you can support yourself in a more effective way on a monthly basis. Sometimes you have to sell off assets to help clear down liabilities to move you forward. You could have four separate spreadsheets, one giving you your outgoing expenses, so expenses for household living and expenses for liabilities, income coming in. Then you list out your assets and your liabilities.
If you’ve taken out a loan in the last three or four months during Covid, bounce back loan for example, as interest will kick in next year you need to plan ahead for that. When somebody tries to measure their wealth in terms of asset base they say I’ve got million pounds worth of property, but how much do you owe of that?
Then the true measure of that net wealth is the assets minus liabilities and you also have to look at the liabilities and assets you hold right now. Sometimes you may be holding onto an asset that actually has the ability to appreciate quite rapidly over time. Other assets may not appreciate then it becomes a conversation with yourself about what if I were to release this asset here as opposed to this one over here?
Asset number one may not appreciate much over the next five years but number two may appreciate over the next five years so if I need to liquidate and create some cash to pull down a liability I let go of the asset that is not likely to appreciate much over the next couple of years simply in this example.
I’m looking ahead for the next five years and thinking it make sense to hold onto the one that will go up and clear down some debt unless, of course, it happens to be the one that is quite flat is a property for example, that; s producing a lot more cash flow and that gradient is going up like this.
For a property investor the dilemma becomes then what do I sell?
The capital growth property or the income property and that comes down to your own personal strategies. You can see how all this fits together and how important it is to consider the factors.
So income and assets, liabilities and expenses all work together in harmony.
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