The holy trinity - assets, liabilities and cash flow

As we start earning, investing and growing in our lives, we tend to build a portfolio of assets & liabilities. Many times the difference between assets, liabilities and cash flow tends to get blurred. In this post, I try to explain the difference between the three. 

• Lets take the easy one first - cash flow. Money coming into your account is incoming money & money going out is outgoing money. Together it forms a bi-directional cash flow. It doesn't take a genius to figure that out 😃. The problem comes when you get incoming money with strings attached, that over time ensure that the you end up spending more than what you really received. A classic example of that is personal loan. For example, if you take a personal loan on Rs. 1 Lac at 11% rate to be given back as EMIs spread over a year, then you will end up paying at least Rs. 11,000 extra - assuming no processing fee, on-time payment, etc. In such situations, what you did with that principal will determine whether this was a good cash flow or a bad one. 

• Assets : Assets are instruments that appreciate in value (or at least match inflation) AND give a steady incoming cash flow. An example of such an asset is stocks like ITC, TCS, L&T, etc whose value steadily appreciate and also give a good quarterly dividend (incoming cash flow). Real estate in a growing city (completed houses that are given out on rent) is another example. Here the value of the property tends to beat inflation in appreciation and also gives a steady monthly rental revenue. Once an investor has 2-3 such types of assets (good stocks, house, etc) then the dilemma of where to invest available money comes - meaning, which asset gives a better return over time. 

• Liabilities : Liabilities are instruments that depreciate in value (at least due to inflation) and have a steady outgo of cash flow. A classic example of a liability is a vehicle (scooter, car, etc). The value starts depreciating the minute you drive it out of the showroom and you spend every month on the vehicle (maintenance, petrol, etc). Many times we tend to take on liabilities as it gives us material comfort - it "makes our life easy". 

Other than these, there are a whole category of instruments that shift between an asset & liability depending on markets - i.e. external forces not in your control. Gold is one such asset. Stocks that give a steady dividend but whose stock price keeps fluctuating is another such instrument. So, the next time you examine your portfolio, take a good hard look at what really are your assets, what are your liabilities and what fluctuate. 

How profits are made

We tend to buy a stock, mutual fund, house, etc. at at time when we have sufficient cash and then we wait patiently for the asset's value to grow. We wait for the value of the underlying asset to appreciate so that we can sell at the right price and make a tidy profit. There is a lot of literature that talks about the virtues of being patient while investing and how money "compounds" over time. However, many of us don't realize that profits are decided when we buy, not when we sell. 

Profits are made when you invest in a really down market. When everything is so beaten down & low that you get to "choose" what to buy and at a "price that is unbelievably good" compared to what it should actually be. So keep some cash in a FD, as an investable money, and use it when the bears run the market - not when you see euphoria and new record highs. Your patience should not only be in staying invested, but, also in waiting for the trough to come when you can buy.

The three types of income

Over the last decade & half of earning, saving and investing, I have realized that any working professional tends to have three types of incomes. Each of these incomes have a different growth & risk potential and depending on the professional's age and risk taking capacity, they contribute differently to the professional's portfolio.

• Earning income : This is the income that we earn by working - i.e as a compensation for the skills that we learn & implement for someone else. The earning income mostly tends to grow proportionate to the circumstances - growth of the industry, growth of the company, promotion, etc and of course based on the individual's own ability to excel in these circumstances. For professionals working in normal growth companies, the growth in earning income is generally inflation + X %. X being dependent on how fast the company is growing. X tends to increase (one-time) when the person gets promoted, shifts a job, takes up a new role, etc. The greatest advantage of earning income is that it gives a steadiness to the cash flow. Unless you do an epic screw-up, you know exactly what will be your incoming salary for at least 12 months, if not the next 3-4 years. That helps you plan your savings, expenses, investments, holidays, etc. Of course the disadvantage of this income is that its growth is capped at a certain level commensurate to how the industry & company is growing. Both the industry AND the company have to grow, else your salary growth is sub-optimal. At the early stages of an individual's career, earning this income consumes maximum time & effort and less time is spent on other types of income. 

• Portfolio income: As the individual starts growing in his career, his thoughts veer towards "additional sources of revenue". He wants to de-risk himself and be less dependent on circumstances (growth of industry, company, etc) to grow his own wealth. He also realizes that his savings tend to lie in the bank or FD giving sub-optimal returns and he starts looking at other options of investments. This leads him to explore ways of using his existing money (savings) to create more money. The portfolio income starts kicking-in when he starts using his money to make more money instead of using professional skills (as in a job). The most common portfolio income avenues in India are mutual funds, stocks and then the more exotic ones like derivatives. The advantage of portfolio income is that it de-leverages the individual from what is happening in his industry & company. It lets him tap into larger growth waves in different industries and to ride that wave to make money. It also brings a non-linearity to growth as he can seek growing stocks/mutual funds/etc instead of waiting for his industry to grow. The major disadvantage with portfolio income is that there is a steep learning curve before you start making serious money. So, it is time consuming and many times in tends to become a gamble rather than a planned investment. 

• Passive income: This income comes into play once the individual has worked for a few years and starts looking at acquiring "assets". Assets normally have a large upfront investment amount (Capex) and a steady revenue stream (monthly/quarterly/yearly incoming cash flow) while the value of the asset itself grows. Such assets could be investing in start-ups, investing in land/houses, etc. There has been a lot of debate in India whether houses are an asset with good returns or whether one should stay away from it - I will hold my comments on it for a subsequent post. The greatest advantage of the passive income is that it doesn't consume your time & effort after the initial investment. Still it keeps giving you a steady revenue AND the value of the underlying asset itself also keeps going up. The flip side to such investments is that they are illiquid in nature - meaning, it is much easier to sell a mutual fund as compared to a house or an investment in a company. 

Depending on an individual's financial maturity and aggression for growth these three types of incomes kick-in at different stages of his life. Once all the three start kicking-in, then, managing the portfolio for optimum growth becomes the next focus area.

Levels of financial maturity

We all know that our net worth is essentially our income & assets minus expenses. Knowing this we focus on growing our income and reducing our expenses so that savings increase. However, most times we ignore how much year on year growth the savings itself is giving. For example, if my income is Rs. 100 and expense is Rs. 40, then my saving is Rs. 60. I can focus on increasing the income & reducing the expense to increase the saving. However, the saving of Rs. 60 is an available capital that can also be deployed in multiple avenues so that its value increases even if income & expenses remain constant. Realizing the earning potential of one's saving is the first stage of financial maturity.

The second stage of financial maturity comes in knowing what should be the rate of  growth of the saving - both % growth & time taken for the growth. For example, most savings accounts give 4-5 % interest per year and most fixed deposits give 6-7 % interest per year. However, with an inflation of say 5 %, the effective interest rate for a savings account is almost zero and for an FD it is about 2%. Also, the time taken to earn the negligible interest is one whole year. Compared to this, if say an equity investment gives a 8 % return in 6 months, then it would be a substantial growth of capital as compared to savings account & FD. 

The third stage of maturity comes in realizing that inherently large investments give small % returns but the absolute value is high. Perception of risk inherent in the investment, also plays an important role. For example, a 1 L investment in equities giving a 10 % return in a year gives a profit of 10 K. However, if you invest 50 L in a house and it gives an appreciation of 1 % in a year, then that's a far higher profit of 50 K (assuming no housing loan). Depending on the type of investment instrument and risk perception, the absolute capital we invest also changes. For example, we would be ok with investing 50 L in a house - even taking a home loan if required. However, we would think a few hundred times before investing 50 L on a stock, let alone taking a loan to do the investment. 

Over the next few posts, I will delve deeper into each of these financial maturity stages and share my experiences.