Real assets are the assets that companies seek to acquire, to build and to invest in. Financial assets are the resources that they raise to allow that to happen. The distinction underpins what we call corporate finance – the financing of corporations.
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When economists talk about the real economy, what they mean is the flow of goods and services that actually have value to people. This can be physical goods like cars, houses or computers. But it can also be services, such as going on holiday, going to the restaurant and leisure, just enjoying time, doing whatever you want. These are all things that give people pleasure, satisfaction, utility, however you want to describe it. And it’s the sum of these real goods and services that are the true measure of how wealthy an economy is, the true measure of national income.
(Obviously there is more than this total flow of goods and services in judging how successful a society is, we might want to look at the distribution of income and other measures of welfare such as health and so on, but that’s a topic for another day.)
“Real” here has the same meaning as when we talk about real income – income adjusted for inflation. What matters to you is presumably what you can actually buy with your income; if your nominal pay has gone up by 10% but so have prices, then your real income is unchanged. We economists assume that people care about real things, not nominal.
Real assets are the assets that help to produce these goods and services. An asset is anything that has the potential to create a flow of future benefits. Now real doesn’t necessarily only mean tangible. In fact, most of the assets in a wealthy society are intangible, such as knowledge, skills, know-how, some of which are captured in the form of intellectual property like patents. But most intangible assets are tied up in the form of human capital which we can’t directly observe and which is very hard to measure, yet is extremely valuable and indeed probably the most important source of a country’s underlying wealth.
The key idea: financial assets always (*) have a counterpart liability
So by contrast, what is a financial asset? Like any asset it is a potential source of future benefits. But unlike a real asset, a financial asset always has a counterpart financial liability. A liability is something that has the potential to incur costs or obligations in future. That’s to say, financial assets are bilateral contracts – there are always two sides, two parties, to a financial asset.
Let’s take a simple example. If I have taken out a bank loan, it’s an asset to the bank because I owe them money; but it’s a liability for me, because I have to pay it back. A bond issued by a government is an asset to the person who has invested in it i.e. has bought it. It’s a liability of the government, which must pay the interest on it and eventually repay the principal (the amount borrowed). An equity share (or stock) is an asset to the shareholder, but it’s a claim on the company that issued the share, a claim on that company’s profits (if they make any). So a share is also a financial asset with a counterpart liability.
Even a banknote is a financial asset with a counterpart liability, because the banknote is, at least in principle, a liability of the central bank that issued the banknote. Unfortunately that doesn’t mean much in practice. If you own a UK £20 note, for example, it says on it: “I promise to pay the bearer on demand the sum of £20″. If you actually take that to the Bank of England, and go inside to the bank counter (you can actually do this), all they will give you is another, nice new £20 note, or perhaps they’ll give you two £10 notes. The point is, there’s no underlying other stuff that they can or will give you, but the banknote is, at least notionally a liability of the Bank of England, the UK’s central bank.
Now, this feature of financial assets means that all financial assets and liabilities net out to zero – they all cancel out. The value in total of all financial assets and liabilities is zero because every financial asset is a bilateral contract with somebody on one side and someone else on the other.
But that doesn’t mean they’re not useful! On the contrary, financial assets are the means by which resources flow from people who have surplus financial resources, which we can call savings, to people who would like to use them for productive investment.
So I may have some savings which I intend to draw on in my retirement, and I want to get a return on them, subject to not taking too much risk. At the same time there may be a company that thinks, oh, if only we can raise some funds, we can invest in some real assets and increase our sales in a way that is good for our customers, and if it’s profitable, also good for our investors. So that company is looking for somebody else’s surplus funds to use (with their permission).
A key purpose of the financial system: linking savings and investment
An effective financial system is one that links people with surplus funds with other people that are looking to use those funds. (We call this financial intermediation, though intermediation is just a fancy word for linking together.) The system does this through various financial institutions such as banks, securities markets, pension funds, venture capital and so on. In each case, the suppliers of funds increase their ownership of financial assets, and the users of funds take on financial liabilities. Note that in most cases the ultimate providers of those surplus funds are the general public, ordinary individuals who have savings.
If the financial system is doing its job right, it channels those resources towards the most productive uses, allowing companies to invest, which in turn allows the economy to grow. In this way, the financial system brings about success, both from the point of view of the people who bought the financial assets and the people who sold them, the people who incurred the financial liability.
How all this relates to corporate finance
What does this all mean in the context of corporate finance? A key question in corporate finance is, how companies can raise financial resources in order to build, or to invest in or to improve the real assets that constitute their business?
Depending on the business, it could mean physical assets, such as building a factory or warehouse, or new computers. But in advanced economies, a large part of those real assets will be invested in research and development, in training people. Those assets are just as real, but they’re intangible.
Rich economies have a high proportion of intangible assets relative to tangible assets. Tangible assets still matter though. We need the underlying infrastructure, roads, energy systems and so forth, without which those intangible assets are not very useful. But one mark of an advanced or richer economy is that it has built a pretty good physical infrastructure base and it’s now moved onto the stage where most of the assets it’s investing in are intangible, especially in the form of human capital
So when you hear economists or finance people talking about real assets or the real economy, they’re using real in this sense, that what ultimately matters is the flow of goods and services that are produced by real assets. By contrast, financial assets are a means to achieving that end. Financial assets are important, potentially very useful, but underlying everything, they have no intrinsic value. They are merely claims on the value created by real assets. And it’s how an economy produces and invests in real assets that ultimately determines the wealth that’s generated.
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(*) There are two conventional exceptions. i) Monetary gold, namely gold held by central banks, is conventionally defined as a financial asset, even though it is a tangible real asset. I can own gold outright, nobody else is involved, so there is no counterpart liability. ii) Special Drawing Rights (SDRs) are assets created by the International Monetary Fund (IMF) and allocated to its member countries, which can use them in settling debts between each other. They are not classified as liabilities of the IMF though, partly to avoid them looking too much like money. If you judge that cryptoassets such as bitcoin are financial assets, then they too are exceptions to the rule, because they usually do not involve any counterpart liability.
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