We have seen assets and liabilities so far. If you have not read the post, you can read it here. In this post, we will understand some lesser-known uses of assets and how they help the rich become richer. But before that, we need to understand a few terms.
So first of all let’s start by understanding these terms.
Credit History
Credit History refers to the history of an individual and company’s borrowing and credit repayment.
It helps lenders evaluate the risk profile of the entity. A good credit history indicates responsible financial behavior. A good credit history leads to lower interest rates on loans reducing the burden on the borrower.
Leverage
Lever in simple words means to use a helping hand for pulling off something which you couldn’t have pulled off by yourself. For example, as shown in the below image if we wanted to lift the heavy stone by ourselves, we wouldn’t have been able to by ourselves, but by using leverage, it becomes very easy.
Financial leverage is the concept of using borrowed capital as a funding source. Leverage is often used when businesses invest in themselves for expansions, acquisitions, or other growth methods.
There are two types of leverage: secured and unsecured.
Secured leverage involves the use of assets for borrowing capital and usually carries lower interest rates. The assets can be anything including equity, bonds, real estate, and precious metals.
Unsecured leverage does not involve the use of assets and usually carries a higher interest rate as compared to secured leverage.
Cashflow
Cash flow is the movement of money into and out of an entity over a certain period. If the company’s cash inflows exceed its cash outflows, its net cash flow is positive. If outflows exceed inflows, it is negative.
Suppose you received INR 1 Lakh, then this is a positive cash flow as the money has come into your pocket. But if you have to pay someone INR 2 Lakhs it is negative cashflow as money has come out from your pocket.
Capital/Corpus
Capital or corpus is the amount available at the disposal of the entity or company. Suppose you have INR 5 Lakhs in your bank account and apart from this you don’t have money anywhere else then this is your corpus, or suppose you have INR 6 Lakhs invested in a mutual fund then INR 6 Lakhs is the corpus invested by you.
Cost of borrowing
It is the amount that the borrower pays for using the capital, alternately it is the reward for the lender for the risk the lender is taking.
Suppose you take a loan of INR 1 Lakh at a 10% p.a. interest rate then the capital you have borrowed is costing you INR 10K to use per year, this is compensation for the lender for the risk he/she is taking by lending the money to you.
Use of the above terms
So let’s take a scenario where there are two people who have a business opportunity in front of them. Let’s call these people, persons A and B. Person A and B have the same business opportunity in front of them, the only difference between person A and B is that person A has a considerable amount of assets which amount to a good corpus, whereas B does not have assets.
Both persons A and B are planning to use leverage to exploit this business opportunity. Now B has a straight path, he/she has to take unsecured leverage since he/she doesn’t have any assets. But for person A he/she has two ways, either he/she can liquidate their assets or take secured leverage against their assets.
So what do you think person A should do? Should he/she liquidate their assets or take a secured leverage against their assets?
Now if person A is a strategic thinker he can take secured leverage against his/her assets and use it for the business. This not only helps them to enter the business opportunity but also enjoy the benefit of their assets appreciation and cash flow with a certain amount of interest on the borrowed capital.
Now let’s say there is one more additional person called C. C also has the same amount of assets as person A, but with a catch, person C has a better credit history than person A which allows him/her to get leverage at a lower interest rate than person A.
Thus the cost of borrowing for person C is less than for person A, which helps him/her to generate more returns on the borrowed capital.
Now consider a person D who may or may not have assets, but borrows capital not to put to use in some productive purpose but puts to unproductive use such as spending on unnecessary things. This leads to an increased cost for him/her due to the absence of returns generated on the borrowed capital.
How to use Leverage?
So coming on to the point of this post. How should one use leverage?
The very first thing to note is that leverage is a double-edged sword, as it can work in your favor as well as against you as was seen above in the case of person D. Thus if you are borrowing capital for an unproductive cause it can cost you and you might miss opportunities that you could have exploited.
So in the real world, persons A and C are rich people who focus on accumulating assets and then leverage those assets to make more assets. These assets can be purely for capital gains, cash flow, or both.
Meanwhile, B is the case for any common person who doesn’t acknowledge the value of assets and is poised to miss out on opportunities, and if he/she tries to exploit the opportunity then they have to pay a higher cost for the same compared to person A and C which in turn leads them to generate lower returns.
I prefer to own cashflow-generating assets which help me exploit opportunities as well as prove as an alternate source of income.
This is all for this post. Tell me your thoughts on the above.
I’ll see you all in the next post. Don’t forget to follow my Facebook and Instagram pages for regular updates. Until then, keep learning.