• Arne

Your key to success: think of yourself as being a corporation

Have you ever wondered how the wealthy manage to produce an income that is by far greater than that of the average Joe? The answer is straightforward: they adopt the concept of income producing assets.

First, to understand the definition of an income producing asset, let me take you on a short ride through the fundamentals of your personal financial statement. I would assume you have never seen your financials this way before.

Balance Sheet and P&L.

Presumably, you are already familiar with the concepts of corporate accounting. However, let me provide a short recap on the fundamentals:

A business owns assets. Those assets may be categorized in different ways according to generally accepted account principles (GAAP's). All assets a company owns at a particular date such as property, land, equipment, office furniture, buildings, software, cash at bank etc. are listed on the asset side of the balance sheet. On the other hand, a company too has obligations. They are called liabilities and come in the form of bank loans, pension reserves, accruals etc. They are stated on the liability side of the balance sheet. Usually, the amount of assets exceeds that of the liabilities. The gap is what is called equity.

Naturally, all assets are intended to generate earnings - either direct or indirect. Indeed, in a business context, an asset should be called an asset only if it has the ability to increase the companies earnings. The Profit & Loss (P&L) statement provides an overview on the company's ability to generate earnings. The structure of the P&L and its content may too vary based upon different GAAPs, but the idea is always the same: revenue minus expenses equal earnings. What's left as earnings (after all obligations including tax, interest etc. have been paid) is what belongs to the owners of the business. They can either use it to pay dividends, to repurchase stock or to reinvest in other projects.

Think of yourself as being a corporation.

Most people never think about their personal financials in the same way a company does, even so it is critical for your financial success. To understand this, let's assume a middle-aged lawyer called Harry who studied at a top ranked university, earns about EUR 6.000 after tax salary and lives in his own apartment which he bought for EUR 600.000. Of course, he has regular living expenses plus taxes. When asked, Harry would probably draw his financial statement similar to this:

Now, on the other hand, take Sarah who is a smart investor and at the time Harry's colleague. Suppose they have studied at the same university, earn the same salary and also bought a similar apartment. Unlike Harry, Sarah is renting out here own real estate while she lives in another apartment for rent. Also unlike Harry, Sarah is not holding her monthly savings as cash at bank, but rather reinvests in securities such as stocks and bonds. When asked, Sarah draws the following:

Sure, this example is over simplified, but you should notice the difference right away. Sarah has true assets in here balance sheet that are generating (passive) income to her. Those green marked assets are assets in the understanding of a corporation, because they generate revenues to her. Harry, on the other hand, has no real assets at all - beside his labour that he sells to the law firm for income from employment in return.

You may wonder why the real property for Sarah is an asset while for Harry it is not. That is, Harry's home is only generating expenses in his P&L, while for Sarah it too generates income. Of course, it might be the case that Harry's apartment gains in value, but why should it matter if he will never sell it?! Always bear in mind:

"A true asset generates recurring income on a periodic basis."

Hence, as a smart investor you would be more interested in the monthly (or yearly) earnings that your stocks, bonds or real estate provides, instead of selling them only once. And if you are even among the most intelligent investors, like Sarah, you would take your income after all expenses to reinvest to buy more stocks, bonds or real estate to increase the power of compounding returns.

I have already stressed this example to be oversimplified, but it explains well the concept of how you should see your financials. Eventually, the number I made up may indicate that you can only invest when you already earn above average salary from employment. This is not true. You can also invest in stocks if you are earning way less. Of course, the fraction that you would invest in stocks, bonds or real estate per month would be smaller. Investing is like planting a tree: first, it seems nothing happens and then, suddenly, wealth is spreading thanks to compounding returns.

Unfortunately, most people still have only one source of income which is their labour-power. Eventually, you should try to build up more income streams from different source.

If you'd like to learn more on this topic I would highly recommend you have a look into Rich Dad, Poor Dad here*. It provides great ideas how to manage yourself.