We finally reach the central idea of this site.
The very first 11th-floor meeting was quite straightforward. Sarah Hudson, a loving mother, and a fresh new entrepreneur wanted to discuss wealth with her neighbors. After this fundamental announcement, there was a brief pause, soon broken by Garret’s voice.
Garret: There is a very important misconception about the way regular people manage their money. (Now, seriously!) Most of us think about money in terms of just inflows and outflows. That is an incomplete concept, though, and it leads to big misunderstandings about one’s financial position. What we often see as a result is personal tragedies.
Sarah: You’ve got my attention.
Garret: So, let me explain the right way of doing things and you will see the difference.
Your material wealth is basically everything you own that has a value measurable in money.
Money measures the value of goods, services, and other transactions.
So, let’s see how this works.
There are two basic types of systems for measuring wealth. You can measure it at a specific point in time, like taking a happy photo of your wealth on New Year’s Eve. Or, you can measure the change in your wealth between one specific date and another (like making a movie of the past year).
Let’s take a look at the first method.
Wealth = things we own – things we owe
Things we own – For the purpose of calculating material wealth, these are things with a monetary value (easily measurable in money). They could be sold, and/or they enable us to generate income. Such things we own are called ASSETS. Examples include a car, a house, shares in a company and cash.
Things we owe – These things (or quantities) are also easily measured in terms of money. They include money we owe to banks, suppliers, friends and governments. The things or amounts we owe are called DEBT. (Surprised?) Examples include cash loans, credit card balances, purchases not yet paid for, and taxes. Here we have:
Wealth = Assets – Debt or
The last equation is called a Balance Sheet and is regularly reported by every corporation around the world. We can conclude that when you measure your assets on a specific date and subtract your debt at that same date, you know your wealth at that point in time.
Think of your Balance Sheet as a camera. You use it to make happy photos of your WEALTH at certain dates. By comparing a couple of these photos, you can see the changes that occurred between their two dates (like one of those “before and after” commercials).
Now let’s take a look at the second method of measuring your wealth. This one measures the change in your wealth from one specific date to another – for example, from the beginning of one year to the beginning of the next. The amount of that change is called profit (if your wealth increased) or loss (if it decreased). Your profit or loss for a period is calculated by subtracting your total expenses for that period from your total income during that same time.
ΔWealth or Profit (Loss) = Income – Expenses
Think of your Profit and Loss Statement as a video camera. You use it to make a video of a day, a month, or a year of your WEALTH. It shows you the dramatic (or not-so-dramatic) changes that took place during that period.
Let’s look again at the terms “income” and “expense.”
INCOME – As we covered earlier, income is generally said to be the net economic benefits you have received in a given period.
EXPENSE – An expense is generally thought of as money you spend, or a cost incurred. However, in some cases, money spent is thought of as an asset. That may be a new concept to you, so I will explain it.
How can I distinguish whether I should think of money I spend as an expense or an asset?
As unexpected as this may sound, that distinction is up to you. First, look at the definition of “asset.” If what you spent money on, doesn’t fit that definition, what you paid for was an expense. Here are some questions to ask, to help differentiate assets from expenses:
- Do you expect any income from the item or service you bought? Is it a tool (in a literal or figurative sense) for generating income?
- Does it have significant material value?
- Do you expect it to have a significant material value after a year?
- Could you sell it after a long period of time (say, a year)?
If you answered yes to some or all of those questions, you probably have bought an asset.
Some questions for you:
- What is your understanding of material wealth?
- Do you own any assets?