Investor Lesson 14 - Financial Literacy Made Simple

“Your dad struggles financially because he is word literate, but not financially literate,” rich dad often said to me. “If he just took the time to learn how to read numbers and the vocabulary of money, his life would change dramatically.”

Financial literacy was one of rich dad's six lessons in Rich Dad Poor Dad. To rich dad, financial literacy was crucial for anyone who was sincere about being a business owner or a professional investor. In later sections of this book, Sharon and I will be going into greater detail on the importance of financial literacy as it pertains to business and investing, and how to find investment opportunities that the average investor misses. But for now, I think it best to quickly review financial literacy and how to make it simple and easier to understand.

A sophisticated investor should be able to read many different financial documents. At the center of all the documents are the income statement and the balance sheet.

I am not an accountant, yet I have attended several classes on accounting. In most of those classes, what struck me was how the instructors focused on one of the documents, but not the relationship between the two documents. In other words, the instructors never explained why one document was important to the other.

Rich dad thought the relationship between the income statement and the balance sheet was everything. He would say, “How can you understand one without the other?” or , “How can you tell what an asset or liability really is without the income column or the expense column?” He would go on and say, “Just because something is listed under the asset column does not make it an asset.” I think that statement was the single most important point he made. He would say, “The reason most people suffer financially is because they purchase liabilities and list them under the asset column. That is why so many people call their home an asset when it is really a liability. ” If you understand Gresham's Law, you may know why such a seemingly minor oversight can cause a lifetime of financial struggle instead of financial freedom. He would also say, “If you want to be rich for generations, you and the ones you love must know the difference between an asset and a liability. You must know the difference between something of value and something of no value. ”

After Rich Dad Poor Dad was published, many people asked, “Is he saying that a person should not buy a house?” The answer to that question is “No, he was not saying do not buy a house.” Rich dad was only emphasizing the importance of being financially literate. He was saying, “Don't call a liability an asset, even though it is your house.” The next most asked question was, “If I pay off the mortgage on my house, will that make it an asset?” Again, the answer in most cases is “No, just because you have no debt on your home, it does not necessarily make it an asset.” The reason for that answer is again found in the term “cash flow. ” For most personal residences , even if you have no debt, there still are expenses and property taxes. In fact, you never truly own your real estate. Real estate will always belong to the government. That is why the word is “real” (meaning “royal” in Spanish), not physical or tangible. Property has always belonged to the royals. Today it belongs to the government. If you doubt that statement, just stop paying your property taxes and you will find out who really owns your property, with a mortgage or without a mortgage. The non-payment of property taxes is where tax-lien certificates come from. In Rich Dad Poor Dad, I wrote about the high interest that investors obtained from tax liens. Tax liens are the government's way of saying, “You may control your real estate, but the government will always own it.”

Rich dad was very much in favor of home ownership. He thought that a home was a secure place to put your money but it was not necessarily an asset. In fact, once he had acquired enough real assets, he lived in a big beautiful home. Those real assets generated the cash flow that allowed him to buy his big beautiful home. The point he was making was that a person should not call a liability an asset, or buy liabilities that he or she thinks are assets. He thought that was one of the biggest mistakes a person could make. He would say, “If something is a liability, you'd better call it a liability and watch it closely.”

To rich dad, the most important words in business and investing were cash flow. He would say, “Just as a fisherman must watch the ebb and flow of the tides, an investor and businessperson must be keenly aware of the subtle shifts in cash flow. People and businesses struggle financially because they are out of control of their cash flow .”

Rich dad may not have been formally educated but he had a way of taking complex subjects and making them simple enough for a 9 year old child to understand, because that is how old I was when he began explaining these things to me, even though my wealth has increased. And I must confess that I have not progressed much beyond the simple line drawings rich dad drew for me. Yet rich dad's simple explanations allowed me to better understand money and its flow as well as guided me to a financially secure life.

Today, my accountants do the hard work and I continue to use rich dad's simple diagrams as my guides. So if you can understand the following diagrams, you have a better chance of acquiring great wealth. Leave the technical accounting work to the accountants who are trained to do such important work. Your job is to take control of your financial numbers and guide them to increasing your wealth.

Literacy Lesson #1: It is the direction of cash flowing that determines if something is an asset or a liability, at that moment. In other words, just because your real estate broker calls your house an asset does not mean it is an asset.

This is the cash flow pattern of an asset. Rich dad's definition of an asset was: “An asset puts money in your pocket.”

This is the cash flow pattern of a liability. Rich dad's definition of a liability was: “A liability takes money from your pocket. ”

Rich dad also said to me, “The confusion occurs because the accepted method of accounting allows us to list both assets and liabilities under the asset column. ” He would then draw a diagram to explain what he had just said and say, “This is why it is confusing.”

He would say, “In this diagram, we have a $100, 000 house that someone has put $20,000 cash down on and now has an $80, 000 mortgage. How do you know if this house is an asset or a liability? Is the house an asset just because it is listed under the asset column?”

Rich dad then drew the following diagram, saying, “This is a house that is a liability. You can tell it is a liability because its only line items are under the expense column; nothing is in the income column.”

Rich dad then added to the diagram a line that read, “Rental Income and Net Rental Income, ” the key word being “net.” “That change to the financial statement changed this house from a liability to an asset.”

After understanding the concept, rich dad would add the numbers, just so I could understand the concept better. “Let's say all the expenses associated with this house add up to $1,000. That includes, the mortgage payment, real estate taxes, insurance, utilities, and maintenance. And you now have a tenant paying you $1,200 a month. You now have a net rental income of $200. 00 a month, which makes it an asset because this house is now putting money in your pocket, as verified by the $200. 00 income. If your expenses stayed the same, and you collected only $800. 00 a month in rent, you would now be losing $200.00, and even though you had gross rental income of $800.00 a month, the property would become a liability. So even with rental income, the property could still be a liability instead of an asset. And then I hear people say, ‘But if I sell it for more than I paid for it then it becomes an asset.' Yes that would be true but only when that event occurs sometime in the future. And contrary to popular belief, the price of real estate does go down on occasion. So the saying ‘Don't count your chickens before they hatch,' is a wise bit of financial wisdom.”

Literally billions of dollars were lost on real estate after the 1986 Tax Reform Act. So many speculators lost money because they were willing to buy high-priced real estate and lose money on the assumption that the price of real estate would always go up and the government would give them a tax break for their passive real estate losses. In other words, the government would subsidize the difference between rental income and rental expenses, which were higher. As they say, “Someone changed the rules.” After the tax law change, the stock market crashed, savings and loans went broke, and a huge transfer of wealth occurred between 1987 and 1995. Investment property flowed from primarily the S quadrant—the high-income professionals, such as doctors, lawyers, accountants, engineers, and architects—to the investors in the I quadrant. That single tax law change forced millions of people out of investing in real estate and into the paper asset market known as the stock market. Could another transfer of wealth from one side of the Quadrant to the other be ready to occur soon? This time, could it be paper assets instead of real estate? Only time will tell, and history does tend to repeat itself. When it does repeat itself, some people will lose, but many others will win.

In Australia today, the government still has laws that allow investors to “negatively gear ” their investment real estate. In other words, you are encouraged to lose money on your rental real estate, with the idea of gaining a tax break from the government. We in the United States had the same tax rules until 1986. When I speak in Australia about investing, I often hear howls of protest about my warnings that the government could change the laws just as they did in the United States. I hear things such as “The government won't change the rules,” and I just shake my head. They just don't realize how painful the law change was to millions of investors in the United States. Several of my friends had to declare bankruptcy and lost everything they had worked years or decades to acquire.

The point I make is: Why subject yourself to the risk? Why not find a property that makes money? Any person can find a property or investment that loses money. You don't have to look too far to find an investment that loses money. You don't have to be smart or financially literate to find an investment that loses money. The problem I have and rich dad had with the idea that losing money was a good idea because of the tax breaks was that such ideas often caused people to be sloppy. I often hear people say even here in America, “It's OK that I am losing money. The government gives me a tax break for losing money. ” That means for every dollar you lose, the government gives you back approximately 30 cents (depending on your tax bracket). To me, there is something missing in that logic. Why not invest so you can have it all, which is security, income, appreciation, and tax breaks?

The idea behind investing is to make money, not to lose money. You can still gain many tax breaks and make money if you are a sophisticated investor. A friend of mine, Michael Tellarico, a real estate broker in Sydney, Australia, says, “People come into this real estate office every day and say, ‘My accountant told me to come in here and look for property that I can negatively gear .'” In other words, my accountant told me to buy a property to lose money on. Michael then says, “You don't need my help to find a property that loses money. There are thousands of them all around you. What I can help you find is a property that will make you money and you will still get your tax breaks.” The reply often is, “No. No. I want to find a property to lose money on.” The same thing was going on in America just before 1986.

1. The idea that losing money is OK because of tax breaks often causes people to become sloppy in choosing investments.

2. These people do not look as hard for real investments. They do not look at the financials as closely when analyzing an investment.

3. Losing money destabilizes your financial position. In other words, there is enough risk involved with investing as it is. Why make it any more risky? Take the extra time and look for solid investments. You can find them if you can read the numbers.

6. While millions of investors lost money in 1986, there were other investors that were prepared for the change. Those who were prepared made the millions that the unprepared investors lost.

Rich dad said, “The riskiest investor of all is a person who is out of control of his or her personal financial statement. The riskiest of all investors are those who have nothing but liabilities they think are assets, have as much in expenses as they have in income, and whose only source of income is their labor. They are risky because they are often desperate investors.”

In my investment classes , I still have people come up to me and argue that their home is an asset. Recently one man said, “I bought my house for $500,000 and today it's worth $750,000.” I then asked him, “How do you know that?” His reply was, “Because that is what my real estate broker said it was worth.”

“Why no,” he said. “He just said that was the comparable average price of houses in the neighborhood being sold today.”

And that is exactly why my rich dad said the average investor does not make much money in the market. Rich dad said, “The average investor has the count your chickens before they hatch mentality. They buy items that cost them money each month, yet call them assets based upon opinions. They count on their house going up in value in the future, or they act like their house can be sold immediately for what their real estate broker told them it is worth. Have you ever ended up selling your home for less than what your broker, or banker thought it was worth? I have. As a result of basing financial decisions on these opinions and expectations, people lose control over their personal finances. That to me is very risky. If you want to be rich, you must take control over your education as well as your personal cash flow . There is nothing wrong with hoping the price of something goes up in the future as long as you do not lose control of your finances today. ” He would also say, “If you're so certain the price is going up why not buy 10 of those houses?”

This mentality also applies to people who say, “My retirement account is worth $1 million dollars today. It will be worth $3 million when I retire. ” Again, I would ask, “How do you know that?” What I learned from my rich dad was that the average investor often “Counts their chickens before they hatch. ” Or they bet everything on one event which means they literally “Wait for their ship to come in,” sometime in the future. In most cases, many eggs do hatch and most ships do eventually come in. Yet the professional investor does not want to take that chance. The sophisticated investor knows that being financially educated gives you more control today and if you keep studying, greater financial control tomorrow. The sophisticated investor knows that sometimes eggs get eaten or stepped on and sometimes the ship people are waiting for is the Titanic.

I meet many investors who are new to the world of investing. They have been investing for less than 20 years. Most have never been through a market crash or owned real estate worth much less than they paid for it where they still must make the monthly payments. These new investors come up to me and spout off industry averages such as, “The market on average has been going up since 1974.” Or “Real estate over time has averaged over 4% per year for the last 20 years.”

As rich dad said, “Averages are for average investors. A professional investor wants controls. And that control begins with yourself, your financial education, your sources of information, and your own cash flow. ” That is why rich dad's advice to the average investor was, “Don't be average.” To him being an average investor was being a risky investor .

People leave school not even knowing how to balance a checkbook much less how to prepare a financial statement. They never learned how to control their finances. And the only way you can tell if people are in control of themselves is by looking at their financial statements. Just because people have high-paying jobs, big houses, and nice cars does not necessarily mean they are in control financially. If people knew how a financial statement worked, they would be more financially literate and more in control of their money. By understanding financial statements, people can better see how their cash is flowing.

When people write checks, they are depleting an asset. And when people use their credit cards, they are increasing their liabilities. In other words, credit cards make it so much easier to get deeper and deeper into debt. Most people cannot see it happening to them simply because they have not been trained to fill out and analyze a personal financial statement.

Unless something changes inside this person, chances are that this person will live a life of financial servitude. Why do I say financial servitude? Because each payment this person makes is making a rich person richer .

AUTHOR'S NOTE: Many people ask me: “What is my first step to financial freedom?” My response is, “Take control of your financial statement.” I asked my tax strategist and accountant, Diane Kennedy, to put together an audiotape program and workbook to:

Diane and I produced these tapes, and we walk you through the process of getting out of debt. More importantly, however, you will learn how to manage your money like the rich do. This is important because most people think that making more money will solve their money problems. In most instances, it does not. Learning to manage the money you do have like a rich person does is how you can solve your short-term money problems. Doing so also gives you the opportunity to possibly become financially free. The audiotape set and workbook are contained in a program titled “Your First Step to Financial Freedom. ” The information found in this educational package is simple, easy to understand, and essential to start building a strong financial foundation. You can find out more information about this audiotape package in the back of this book or from our website at

Literacy Lesson #2: It takes at least two financial statements to see the entire picture.

“Always remember that your expense is someone else's income. People who are out of control of their cash flow make the people who are in control of their cash flow rich. ”

He then drew this diagram, saying, “Let me show you what an investor does, using a home owner and banker as an example” :

I sat there looking at the diagram for a moment and then said, “The person's mortgage appears on two financial statements. The difference is that this same mortgage appears under two columns: the asset column and the liability column.”

“That is why you say it takes at least two different financial statements to see the entire picture,” I added. “For every one of your expenses, it is someone else's income, and each one of your liabilities is someone else's asset.”

Rich dad nodded, saying, “And that is why people leaving school who have not been trained to think in terms of financial statements often fall prey to those who do. That is why each time people use their credit card, they are actually adding to their own liability column and simultaneously adding to the bank's asset column. ”

“And when a banker says to you, ‘Your home is an asset,' they are not really lying to you. They're just not saying whose asset it really is. Your mortgage is the bank's asset and your liability, ” I said, beginning to more fully understand the importance of financial statements and why it takes more than two statements to gain a more accurate picture.

Rich dad nodded and said, “Now let's add cash flow to this picture and we begin to see how an asset, in this example a mortgage, really works: “In this example, the mortgage takes money from your pocket and puts it in the bank's pocket. That is why the mortgage is a liability to you and an asset to the bank. The point I am making is that it is the same legal document. ” “So the bank has created an asset that for you is a liability,” I added. “What an investor does is acquire an asset that someone else pays for . That is why investors own apartment houses. Every month, cash flows into the investors' income statements from the rent, just as their mortgage payments flow into the bank's income statement. ”

“Oh, ” I said. “My savings are my asset and the bank's liability. Again, it takes a minimum of two financial statements to see the complete picture. ” “Yes,” said rich dad. “And what else do you notice about these diagrams?” I stared at the diagrams for a while, looking at the examples of the mortgage and the savings. “I don't know, ” I said slowly. “I just see what you have drawn there. ”

Rich dad smiled and said, “This is why you need to practice reading financial statements. Just as you learn more the second and third time you read or listen to someone, you learn more and more the more you practice being financially literate. More things come into your mind that your eyes often miss.”

“What is not visible from my diagrams is that the government gives you a tax incentive to acquire liabilities. That is why it gives you a tax break for buying a house.”

“The government gives me a tax break for having a liability and taxes me for having an asset?” I asked.

“People get a tax break for losing money?” I asked in bewilderment. “Why do they do that?”

Rich dad chuckled, “As I said, the professional investor must think beyond the price of an investment going up or going down. A sophisticated investor reads the numbers to get the true story and begins to see things that the average investor does not see. A sophisticated investor must see the impact of government regulations, tax codes, corporate law, business law, and accounting law . One reason it is hard to find accurate investment information is that to gain a full picture requires financial literacy, an accountant, and an attorney. In other words, you needed two different professionals to get the real picture. The good news is that if you take your time and invest the time to learn the ins and outs of what goes on behind the scenes, you will find investment opportunities and great wealth, wealth that very few people ever find. You will find out the truth about why the rich get richer, and the poor and middle class work harder , pay more in taxes, and get deeper in debt. Once you know the truths, you can then decide which side of the Quadrant you want to operate from. It's not hard; it just takes some time . . . time that people who just want a hot investment tip do not want to invest.”

I did not have to think about which side of the Quadrant I wanted to operate from. I knew I wanted to invest legally from the inside, not the outside. I wanted to know what the truths were, regardless of if I became rich or not. I now wanted to know how and why the rich got richer .

In the early 1980s, I began teaching entrepreneurship and investing to adults as a hobby. One of the problems I ran into immediately was that most people who wanted to start businesses or invest with greater confidence lacked the basics of financial literacy. I believe that this lack of financial education is why nine out of ten new businesses fail in the first five years, and why most investors think investing is risky and do not make or keep much money.

When I recommended that people take classes in accounting, finance, and investing before starting a business or investing, most groaned and did not want to go back to school. That is when I began to search for a way that individuals could gain the basic knowledge in an easy and fun way. In 1996, I created CASHFLOW, Investing 101, a game that teaches the basics of financial literacy, accounting, and investing.

CASHFLOW is a board game because investing and financial analysis are subjects that you cannot learn by reading. My poor dad the schoolteacher often said, “A teacher must know the difference between what can be taught and what must be learned.” He would go on to say, “You can teach a child to memorize the word ‘bicycle' but you cannot teach a child to ride one. A child needs to learn how to ride a bicycle by doing.”

In the past three years, I have observed thousands of people learning to be investors by playing CASHFLOW, Investing 101 and 202. They learn by doing things I could never teach by writing or by lecturing, just as I could never teach you to ride a bicycle. The games teach in a few hours what my rich dad took 30 years guiding me to learn. And that is why this book is titled Rich Dad's Guide to Investing because that is what he did. He guided me because that was the best he could do. Investing and accounting are subjects that he could not teach me. I had to want to learn. The same is true for you.

The more you read financial statements, annual reports, and prospectuses, the more your financial intelligence, or financial vision, increases. Over time you will begin to see things that the average investor never sees.

We all know that repetition is how we really learn and retain what we learn. Recently, I was listening to an audiotape of an interview of Peter Lynch. I had listened to that audiotape a dozen times before. Each time I listen to it, I hear something new. For over 30 years, rich dad had me review financial statements. Today, I think automatically in financial statements.

When we learn to ride a bicycle, we train our subconscious mind to ride our bike. Once that is done, we don't have to think or remember how to ride a bike as we ride. When we learn to drive a car, we also train our subconscious mind. And that is why, once we have trained our subconscious mind to drive, we can drive and talk to someone else, eat a hamburger, think about problems at work, or listen to the radio and sing along. Driving is (hopefully) automatically handled. The same can happen with reading financial statements.

What takes the longest time in finding a good investment is analyzing the numbers. Learning to read financial statements is a tedious process, especially when you first begin to learn. The good news is that it gets easier and faster as you practice. Not only does it get easier, but you can also review many more investment opportunities almost automatically without thinking . . . just like riding a bike, or driving a car.

We as humans learn to do many things subconsciously. If you are serious about becoming a more successful investor, an investor who makes more money with less and less risk, I recommend training your brain to analyze financial statements. Analyzing financial statements is basic to the world's best fundamental investors, investors such as Warren Buffet.

The way this is done is by a term called “deal flow .” Every professional investor has a continuous number of potential business or real estate investments that need investment capital. Rich dad had Mike and me read, study, and analyze these investments regardless of if we were interested in them or not. Even though it was slow and painful at first, over the years, the process became faster, easier , more fun, and more exciting. So we learned by repetition, and that repetition has paid off by allowing me to retire early, feel more financially secure, and make even more money.

Are you willing to practice filling out your own financial statement and keep it up to date as well as read those of other businesses and real estate investment financial statements?

You will note that it is very similar to the question at the end of Chapter 15. It is repeated to emphasize the importance of financial literacy. This question is very important because one of the costs of becoming a rich investor and investing in investments of the rich is the price of investing time in continual improvement of your own financial literacy. If your answer is “No” to this question, then most of the investments that the rich invest in are far too risky for you. If you are financially literate, then you will be better prepared to find the very best investments in the world.