Most of you might know Robert Kiyosaki, the author of Rich Dad Poor Dad. His explanation of the cash-flow quadrants has its own fan base. For starters, the concept of assets, liabilities, income, and expenses can be quite overwhelming and difficult to understand.
For simplicity, let me illustrate just one small section of it today—“The concept of assets generating income”.
The four buckets
The bucket of Income: When you get paid in exchange for work done well, it's called income. There are many ways to generate income, and each of them has its own dignity and relevance. You could be a doctor, teacher, architect, software engineer, artist, cobbler, carpenter, designer, actor, or small business owner. There are countless jobs and self-employment opportunities for earning income, making it impossible to list them all here.
Think of Income as a large bucket of water. When you spend on food, clothing, shelter, transportation, and leisure, you transfer water to the next bucket called Expenses.
The bucket of Expenses: Ideally, the size of the expenses bucket should be much smaller than the size of the income bucket to leave some leftover. This means that your expenses are well within your income and you have a net positive bank balance every month.
For most people, the size of the expense bucket is much larger than that of the income bucket, so they borrow to maintain their standard of living.
The bucket of Liability: When you borrow money from a bank or a person and agree to pay it back in the future with interest, it is called a loan. A loan is neither an income nor an expense, even though it results in positive cash flow at disbursement (income) and negative cash flow at monthly repayment (expense). A loan should be considered the third bucket, called Liability. Liabilities are things you buy now that have future repayment dates.
Let us take the example of a car. Ideally, a car should be an expense if you could just buy it from your current income, but the costs are so high that you might have to take a car loan instead. It creates an EMI that requires you to allocate some money from the income bucket to the liability bucket each month.
So, now your income must be large enough to meet the outflows of the Expense + Liabilities bucket. This puts additional stress on your income, and the only way to increase your income is to work more hours, put in more effort, or upskill. This is how most people live, and honestly, there is nothing wrong with it. When debts mount, the only known way to increase their income is to work overtime, put in additional effort, or upskill. Sometimes, switching jobs can increase income.
The bucket called Assets: This is the 4th and final bucket. Assets are things that generate more income. It could be rentals, dividends, capital gains, or royalties. The beauty is that income from assets is usually passive; you don't need to put in more effort to increase your chances of generating higher income.
Think of it like a coconut tree. In the initial 3 to 5 years, you might have to take good care of it, water it, nurture it, and protect it. Once it matures, it will continue to yield coconuts for life, and the only effort you may have to put in is adding fertiliser or pesticides twice a year.
Most of them do not unlock this level for two reasons.
1. They do not have excess after deducting monthly expenses & liabilities.
2. They are not ready to wait for the assets to mature.
No Excess? Assets can be created only by allocating a part of your income. If the expenses and liabilities are that high, you may never be able to exit from the rat race. To create assets, a regular systematic investment plan (SIP) is the right way to go. By allocating some money to the asset allocation bucket at the start of the month and optimising the rest to cover expenses and liabilities, you are buying a ticket to financial independence.
Not ready to wait?
Just like the coconut tree takes 3 to 5 years to show visible signs of maturity, mutual funds may take a similar or longer time to begin yielding results. This is where most of them quit, thinking that nothing is happening.
Once the assets are created, the magic starts. You unlock a new income source called Passive Income. This additional income can help cover some of your expenses and reduce the burden on your primary source of income.
For example, if you have a mutual fund corpus of Rs 3 crore, you can withdraw Rs 1 lakh a month for the next 25 years and still have excess money left. Returns assumed at 12 per cent per year.
The monthly withdrawals take care of the rising cost of inflation, too. For the first year, you could withdraw Rs 1 lakh per month; for the 2nd year, Rs 1.05 lakh per month; for the 3rd year, Rs 1.1 lakh per month.
By the 25th year, your monthly withdrawal would be approximately Rs 3.22 lakh.
For this magic to happen, you should be able to invest some money each month, rather than using it all up on expenses and liabilities. A bit of sacrifice is essential today to build a corpus tomorrow.
The writer is a SEBI Registered Investment Adviser (RIA), INA000021757, and author of ‘How to join the top 1% options traders club’
The opinions expressed in this article are those of the author and do not purport to reflect the opinions or views of THE WEEK.
