FINANCE | Your Personal Wealth Creation Plan #1
KINGSTON, March 23, 2021 - Today I was sitting on my patio looking out on this beautiful and exotic country in which we live, and reflected on the number of Jamaicans who truly appreciate this fact. People are so stressed out with the daily drudgery of eeking out an existence, that they are unable to enjoy the essence of this paradise in which we live.
In commencing our discussion on wealth, lets consider the various definitions of wealth.
1. The Concise Oxford English dictionary defines wealth as “an abundance of valuable possessions or money.”
2. Economists define wealth from a more technical perspective: Total of all assets of an economic unit that generate current income or have the potential to generate future income. It includes natural resources and human capital but generally excludes money and securities because they represent only claims to wealth.
3. The Accounting/Finance Definition of wealth says it is a measure of the value of all of the assets of worth owned by a person, community, company or country. Wealth is found by taking the total market value of all the physical and intangible assets of an entity and then subtracting all debts
The need to be efficient and effective in my explanation of wealth, means that I will choose the definition of wealth from the perspective of finance and accounting. Those of us who have studied accounting and finance would have been exposed to the basic statement of financial position equation:
Assets = Equity + Debt (Liabilities)
Our discussion on wealth will be centered around this equation, which many persons take lightly but which is the principle on which accounting is built. To keep things simple and in proper perspective, let us define in simple terms the accounting elements of assets, equity and debt (liabilities) introduced above.
- ASSETS: Resources under your control as a result of past events from which future economic benefits are expected to flow to you (examples: land, buildings and cash at bank).
- DEBT: Your present obligations arising from past events, the settlement of which is expected to result in an outflow of economic resources (example: loans and accounts payable).
- EQUITY: Your residual interest in the assets under your control after deducting all its liabilities
The equation mentioned prior, is a funding equation, and simply means that assets can be funded from only two sources, debt or equity. The value of assets at a person’s disposal should never be the basis for defining wealth. Wealth should be determined by looking at equity. Equity is your stake in the assets at your disposal, hence if all your assets were funded by debt you may seem wealthy, but in essence you would have no wealth because equity would be zero. All the assets in your possession would have a debt claim against them hence in reality you do not own those assets. Consider the information that concerns an individual: Gloria Moore, below:
Gloria Moore has $160m in assets and also $160m in debt. She has no wealth because assets-liabilities (debt)=equity, and in the above case the result is zero.
Now let us look at the table below:
|Mark Robinson||HENRY STONE|
|Equity (Net Worth)||$5m||$49m|
If we were to measure wealth based on assets in an individual’s possession, then Mark Robinson would seem to be the wealthier of the two individuals, with $900m worth of assets.
However, when we match his debt obligations, his net worth or equity is only $5m. On the other hand, if we look at the scenario with Henry Stone, he has only $50m in assets but his debt obligations are only $1m. Hence his net worth is $49m. Henry Stone is therefore the wealthier of the two individuals.
So what is the benefit of debt in wealth creation?
In order to generate wealth, we need to have assets in our possession. Most individuals were not born with wealth, so debt is the vehicle of choice to gain possession of assets to generate wealth. However, debt normally comes at a cost to the borrower (interest), hence funds borrowed must be invested efficiently and effectively to create enough funds to pay the interest cost and earn a profit. Profit belongs to the investor and so creates new equity and thus wealth.
Persons who borrow funds to buy non-revenue generating assets will not create the same level of equity as those who borrow to buy revenue generating assets.
For example, if I borrowed $7m to buy a luxury car and repayed the loan over 5 years, at the end of those five years I would have no obligations, but I will have a car which values significantly less than $7m, for example say $3m.
In fact a closer look will indicate that I would have gained no new equity, because I would have given up cash resources greater than the cost of the car, to service the loan over the five years.
If on the other hand, if I had used the $7m borrowed to invested in stocks, and five years later the stocks have doubled in value, after repaying the loan I would have shares valued at $14m.
When I deduct the Loan principal and interest cost, the difference would be a crude estimate of my gain. There is always the risk of incurring losses when we invest, so that must be borne in mind.
We also need to remember the positive correlation between risk and returns, as returns increase so does the risk.
1. In principle, if we borrow funds for investment rather than for consumption, more wealth is created.
2. Wealth is not measured by the assets in your possession, but by your stake in those assets. Equity represents your stake in the assets that are in your possession and hence equity is the true measure of wealth.
Now that we have established what wealth is, how it is measured and the role debt plays in creating wealth, join me next week when we take a look at how to develop your own personal wealth plan.