The Difference Between Assets and Liabilities
- Understanding your finances prepares you for larger purchases, such as buying a home or investing in real estate.
- A personal financial statement details your assets and liabilities during a certain period.
- Financial statements help you (or your financial advisor) develop a strategy to improve your financial standing.
Financial statements are often thought of as something that only companies need to worry about. But, a personal financial statement can help you track your financial health and hone in on trouble spots and opportunities. Starting the habit of developing and reviewing your finances can help prepare you for larger purchases such as buying a home or investing in real estate. Reviewing your financial statement can also provide you with insight into how credit reports are prepared and how credit scores are determined.
Furthermore, a personal financial statement can help you and your accountant (or financial advisor) provide you with a customized strategy for improving your investments, savings, and cost-cutting performance.
The Nuts and Bolts of a Financial Statement
A personal financial statement has three main categories: assets, liabilities, and equity. Below you will find additional insight into all three categories.
Assets include funds held in checking and savings accounts, retirement accounts, and investment account balances, so-called liquid assets. As well as personal furnishings, a home or a car, which are so-called illiquid assets.
Liquid and illiquid assets
Liquid and illiquid assets both have value. The difference between the two is that liquid assets can be turned into cash almost immediately. On the other hand, non-liquid assets have a longer and more involved sales process before being convertible into cash.
Liabilities consist of any loans you owe or debts you have, including personal credit cards, personal loans, car loans, student loan debt, medical debt, and real estate mortgages. If you own a business, it's important to note that business loans and business credit cards cannot be included in your personal financial statement. Instead, you would develop a separate financial report for your business and record its assets and liabilities.
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Equity is the difference between the value of your assets and your liabilities. If your assets are greater than your liabilities, you will have positive equity, also called net worth. If your assets are less than your liabilities, meaning you owe more than what you own, you will have negative equity or net worth.
Let's dive into each of these in more detail.
What is an Asset?
An asset is something of value owned by a person or company that can generate revenue or cash. The key in this definition is that you own the item. Items that are rented, for instance, an apartment, would not be counted as an asset on your personal financial statement.
The second attribute of an asset is that it can generate cash, for instance, the sale of an antique car, or it can generate revenue, for instance, interest earned on a bank account.
Assets don't necessarily always increase in value. Assets can lose value, such as the depreciation of a car or cell phone as newer models are released, or appreciate in value, such as a home or an investment account.
Most assets are tangible, meaning they have a physical substance like cold, hard cash, but some assets are intangible. Intangible assets don’t have any physical substance and often derive their value from the law—think patents, copyrights, and trademarks.
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To better understand your assets, make a list of all the items you own. Next to each asset, list the amount that it’s worth. Typical assets include:
Cash: any physical currency you have that is not deposited in the bank.
Bank Accounts: money deposited in a savings account, checking account, or Certificate of Deposit (CD).
Trading Accounts: stocks, bonds, mutual funds, and cryptocurrency.
Retirement Accounts: 401ks, pensions, IRAs, and any other retirement accounts.
Cash-Value Life Insurance Policies: if you have a life insurance policy that has a cash value (also called a whole-life policy), include this under assets.
Car: the current value of a car, motorcycle, or boat should be included in this category.
Real Estate: the current market value of your home.
Personal Valuables: the market value of any jewelry, collectibles, or furniture.
Money You’re Owed: if you’ve loaned money to someone else and have a reasonable expectation of being paid back, including the value of what you’re owed in this category.
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What Are Liabilities?
Liabilities represent an obligation or responsibility to make a payment, often due to a direct claim on an asset, such as a mortgage taken out to buy a home. In this regard, liabilities don’t generate revenues or yield cash the way assets do. Instead, they result in an expense, costing you money.
Liabilities can be short-term or long-term in nature. Short-term liabilities are debts that will be paid off within a year. Credit cards and short-term revolving lines of credit are the most typical types of short-term liability.
Long-term liabilities have a life span of more than a year. Car loans, as an example, usually have a five to seven-year life, student loans can have a payment schedule extending upwards of ten years, and mortgages last a whole generation, typically spanning thirty years.
To gain an understanding of your particular liabilities, take out a sheet of paper and jot down each liability you have and the amount owed. Here is a list of the most common liabilities:
Credit Cards: any balances owed on a credit card.
Mortgage: the principal amount still owed on a mortgage. This is also referred to as the pay-off value.
Home Equity Line of Credit: the unpaid balance owed on a HELOC.
Car Loan: the remaining balance owed on a car note.
Student Loan: the remaining balance owed on student loans. If any portion of your student loan has been forgiven, subtract this portion from the balance.
Financial Statements Are a Snapshot in Time
Assets and liabilities can change monthly and sometimes daily. For instance, on Day 1, your liabilities might decrease when you pay a credit card bill, which also results in a higher net worth, only to reverse course on Day 2 when you withdraw money from your bank account, lowering your assets and, with it, your net worth.
Your personal financial statement, as such, is a picture of your financial position at a point in time. Each day, your financial statement changes slightly with ebbs and flows in your bank account, credit card balances, and other asset and liability accounts.
A Walkthrough of a Personal Financial Statement
Now that you have an understanding of what exactly assets and liabilities are, let’s work through an example. Imagine that you have a goal of buying a house as part of building your personal wealth and decide to begin by tracking your assets and liabilities. To help lower your liabilities and increase your assets, you diligently contribute to your savings account, pay off credit cards and invest. Let’s see how to break down your financial statement.
Under assets, you would list all of the assets you own. In this example, you own a savings account with $10,000 in it, a checking account of $25,000, a car that has a book value of $30,000, and a retirement account with a balance of $100,000. Your total assets, then, are $165,000. As for liabilities, you have a car note of $20,000, credit card debt of $10,000, and student loans of $50,000, for total liabilities of $80,000.
When we subtract your liabilities of $80,000 from your assets of $165,000, your equity or net worth is $85,000. Knowing this information allows you to fine-tune your budgeting and investing, taking you that much closer to your financial goal of buying a home.
The Money Wrap-Up
Understanding your assets and the work you’re performing to build them—for instance, starting a business or committing yourself to find a better-paying job—is central to building your cash flow, and with it, your investments, retirement account, and real estate portfolio. Likewise, scrutinizing your expenses and increasing the payments you’re making on liabilities, where possible, can decrease the overall value of your liabilities, thus increasing your net worth.
Mastering the difference between assets and liabilities puts you well on your way toward building your net worth. Begin your journey today of building wealth by establishing a habit of regularly preparing your monthly financial statements.