An asset is defined as anything that puts more money in your pocket than it takes out. However, some people mistake liabilities for assets. It is true that some things put money in your pocket .But in order to be a true asset it has to generate more income than it takes out. I used to get confused with assets, I thought assets were things like cars and houses and sure these things can be used as assets but a majority of times they aren’t.
Assets are important to anyone interested in wealth creation. The wealthy buy assets. Other people buy liabilities they think are assets such as the house mentioned before. From my reading of financial books like Rich dad poor dad, I understand that a house is generally a liability.
Some people may get outraged at that statement because they have a different definition of what an asset is. but the important thing is to understanding how cash flows. A house has bills like water bills, electric bills, maintenance costs, heating bills if you are in cold climate and so on.
The reason people don’t like to think about their house as a liability is because of their attachment to it. A house is where we live and although it is an asset in terms of providing shelter for us. It keeps us warm and protects us from the elements however it is a financial liability. This is because it needs to be maintained. It is important to look objectively at what you own and be aware of how cash flow operates for that particular item. Let’s talk about the Four Asset types and how they generate cash flow for you.
The four asset types
Asset type: #1
Type #1 assets generate high returns on capital investment. They can generate substantial cash on very little capital investment but can be grown by reinvesting profits into the core business for expansion.
An example would be a business like Microsoft or Coca-Cola where the underlying company can earn a good percentage of return on a shareholders equity, (the value of shares issued by a company). This means that each dollar retained in profits is generating an enormous return the following year. During their growth phase, these are companies such as Walmart, Hewlett Packard, Best Buy etc. The best course of action is to pour as much money as prudently possible into the main business so it can expand and earn huge rates of return.
Asset type: #2
Those assets that generate high returns on capital. They yield substantial cash on very little investment but they cannot be expanded by reinvesting in the underlying asset. These are considered to be the second best investment because you can earn large returns on very little money. The downfall is that you have to pay out all of the profits as dividends or reinvest in lower returning assets.
The reason for this is that the core business can’t be expanded through capital infusions alone. An example of this is a patent to a device that generates hundreds of thousands of dollars per year. There are little or no investment requirements once the cash starts coming in .However, the drawback is that you cannot invest in more patents at the same rate of return. Unlike asset type #1 you can’t put that money to work at the same level.
A franchise which is a type #1 asset can build another location generating roughly the same return.
At some point, all type one businesses become type 2 businesses this normally happens at saturation. At that point management will likely repurchase huge amount of stock. This is done to increase the remaining shareholder’s equity in the business or they may pay out cash dividends.
Asset type: #3
Appreciates far above inflation in value but doesn’t generate cash flow
Think of a coin collection or fine art. If your great grandparents owned a certain antique it’s worth increases over time. This antique could potentially be worth millions today in contrast to the small investment they made on it in the past. As it appreciates in value, however, you would not be able to use it to pay for everyday living expenses with it because of the lack of cash flow. These types of assets are typically owned by the wealthy who have enough liquid assets.
Asset type: #4
These store their value and will keep pace with inflation. This type of asset includes furniture from Bernhardt and more. They may cost a substantial amount upfront but they hold their value.They can keep pace with inflation and sometimes exceed it. These assets are typically owned by millionaires because of their ability to hold their value. These assets also have the possibility of being sold for greater or at least what they bought them for even adjusted for inflation.
What asset class interests you the most? Leave a comment below, subscribe to my newsletter and as always stay focused