Your financial balance sheet measures the difference between your assets and liabilities to determine whether you’re in debt or if you have equity (net worth).
Assets are things that either generate cash flow for you, or that could potentially create cash flow.
Liabilities are things that incur expenses, such as a loan.
When you have more assets than you do liabilities, the equation is: assets – liabilities = net worth. The greater the assets versus liabilities, the greater the net worth.
Debt is having more liabilities than assets, meaning if you sold everything that you own and you still owed someone something.
Not all liabilities are debt.
For example, suppose your home is worth $500,000 but you only owe $200,000. Most people in that situation would consider themselves to have $200,000 of debt, when if fact is a $300,000 equity position. The asset is worth more than the liability owed.
Now suppose your home was worth $300,000 and you owe $350,000. How much debt do you have? Again, most people would answer “$350,000,” when in fact there is only $50,000 of debt.
Why It Matters To Your Prosperity
You do want to avoid true debt (having more liabilities than assets), but you don’t want to avoid incurring liabilities (owing something to someone else) that can be beneficial to your productivity, value creation, and prosperity.
In fact, in many instances, the way to increase your prosperity and wealth is to increase—not decrease—your liabilities.
For example, suppose that you had a strict rule to avoid debt at all costs—but you misunderstand its definition.
You find a house that you know you can sell for $200,000, but it’s offered at $150,000. You don’t have cash to pay for it, so you decide not to buy it because you don’t want to go into debt.
However, you’re not technically in debt—you would have an equity position of $50,000. By incurring the liability of a temporary loan, you create the possibility of earning $50,000.
Wealth isn’t created by ridding your life of as many liabilities as possible.
Rather, it comes by identifying which liabilities are consumptive (take more value from your life than they put into it) and which are productive (provide more value to your life than they take from it), and then focus on increasing your productive liabilities.
Different Types of Liabilities, & How to Manage Each
We’re often taught to get rid of as many liabilities as possible so that we can “save” money.
It is true that liabilities usually translate into expenses on our income statements. However, those liabilities also often translate into assets, income, or both.
The key is to examine closely the types of liabilities we incur.
There are three types of liabilities: destructive, consumptive, and productive.
Destructive liabilities are things that do nothing but detract from our ability to produce and damage our human life value.
For example, if I use heroin, that is a liability that has nothing but a destructive effect, both on my human life value and on the value I could potentially create for the people around me.
Destructive liabilities also include activities like gambling, pornography, addictions, and engaging in criminal and destructive behavior.
Consumptive liabilities are examples of personal consumption that may not increase our income, but that often have an indirect positive effect on our ability to produce.
For instance, if you buy a new sofa, you may enjoy that sofa and the comfort in brings to your home for years, improving your happiness and potentially making you more productive.
Likewise, though a car does not generally contribute to our cash flow, it makes our lives easier and more productive through fast and reliable transportation.
Productive liabilities are any liabilities that are attached to a corresponding asset that provides an increase in our immediate or possible positive cash flow, even in the long-term.
Real estate is an excellent and simple example of this. If by incurring a liability in the form of a mortgage payment a person is able to control an asset that pays them more than the liability, this is productive and desirable.
If a person decides to go back to school to earn a degree and can turn that degree into a new career that allows her to live her Soul Purpose, increase her human life value, and increase her income, then the student loans she takes out are likely productive liabilities.
Here are the rules for managing liabilities productively:
1. Never have destructive liabilities. Get rid of anything in your life that destroys your human life value and your ability to produce.
2. Choose your consumption wisely. Never incur consumptive liabilities that exceed your assets and therefore put you into debt.
For example, a trip to Hawaii may be consumptive, but if it doesn’t put you into debt and it indirectly increases your ability to produce by giving you much-needed rest and relaxation, then you can feel great about it.
(A word of caution: Be very careful never to use this rule as justification to be overly and irresponsibly consumptive. It’s very easy to slip into the habit of justifying purely consumptive purchases with the thought that it will increase your productivity.)
This gets complex when people use this idea to consume more than is reasonable, or in such ways that lead them closer to being in debt.
For example, if people use this rule as justification to eat out at a five-star restaurant every night and they don’t currently have the cash flow to support such a habit, then they’re abusing this rule.
3. Never borrow to consume. A good way to make sure you stick to rule 2 is to pay cash for everything that does not directly produce for you.
For example, if your only use for a big-screen TV is to put it in your home and use it only for you and your family, this is consumption; you should not put it on credit.
On the other hand, if you own a home theater installation business, it may be productive for you to put a big-screen TV on credit to place in your showroom.
If by doing so you increase your income greater than the liability of the TV, then this is an acceptable use of credit.
4. Focus on increasing productive liabilities, or the liabilities that come with a greater corresponding asset.
If your cash flow created by incurring the liability is greater than the liability, then this is a productive use of liabilities.
Garrett Gunderson is an entrepreneur, financial coach, the founder of Freedom FastTrack, and the primary author of the New York Times bestseller Killing Sacred Cows: Overcoming the Financial Myths that are Destroying Your Prosperity.
Garrett loves inspiring others to turn their potential into production. He has dedicated his life to living and teaching a unique concept known as Soul Purpose that reveals how anyone can live a more prosperous and rewarding life.
As a finance and business productivity coach, Garrett instructs both large and small groups of business owners and financial service professionals nationwide.