Assets and liabilities are two key terms when it comes to accounting and balance sheets in particular. On a company's balance sheet, assets equal liabilities plus owner's equity. Ensuring that everything balances out is hugely important for any business in terms of maintaining its financial health. It is therefore imperative that company owners understand precisely what each term means and how they impact the company. In this article, we look further at the concepts of assets and liabilities.
What Are Assets?
An asset is something that a company has that is of value to the company. Assets can be of both tangible as well as intangible variety. So for example, tangible assets that a business may own can include inventory, equipment, and real estate among other things. As far as intangible assets, we're looking at things such as trademarks, patents, and copyrights for example. Also in this category are accounts receivable as this is valuable to the company upon collection.
When calculating a company's assets, you need to take into account all relevant assets. So this would mean fixed as well as current assets. And of course, you cannot leave out those intangible assets in this formula. Again, among the assets you will include in your tally are current assets. Current assets can be converted to cash relatively easily—usually within less than one year.
Fixed assets, on the other hand, cannot be converted to cash that quickly or easily. In this category, you will find things such as real estate, furniture, vehicles, and machinery. You would also include any investments in your asset calculation. Stocks and bonds would be lumped in with investments. And then finally, as noted, you will factor in those intangible assets that the company owns: patents, trademarks, etc.; you could even count things such as the number of followers you have across your social media accounts as this also brings value to the company.
What are Liabilities?
A liability, as you might expect, is a negative value attached to the company. Liabilities, like assets, fall into both long-term and current categories. Debts are essentially the main form of liability that a company has. That said, there are other kinds of liability that you need to be aware of and subsequently list out on the balance sheet.
When identifying the current liabilities that you have, you are looking for those debts and financial obligations that are generally set to be settled within a one-year or less period. So these are your short-term debts. Among your current liabilities are things like payments to vendors and suppliers; this might also include your monthly expenses such as rent, utilities, and any accounts payable owed.
As far as the long-term liabilities are concerned, here you will be listing things that tend to get paid off over a few years. Any mortgages on a fixed asset might be included in your long-term liabilities.
Understanding Owner's Equity and the Accounting Equation
Equity signifies how much owners have about the assets of the firm. It is defined as the total amount of a company's assets that are claimed by the owners of that company. It is also called shareholders' equity.
Now that we've reviewed each of the relevant terms that go into this calculation, let's take a look at the basic equation involved with assets, liabilities, and equity. This is among the most common equations used by businesses to maintain their balance sheet and keep it up to date.
It is called a balance sheet because ultimately (if done right/) everything must balance out in the end. In other words, the total assets of a business have to equal the total of its liabilities plus shareholder equity.
So simply put, the equation looks like this: Assets = Liabilities + Owner's equity. If the owner's equity plus liabilities don't equal the assets, then the balance sheet isn't balanced, and it is thus time to revisit those numbers to see where the problem is.
Why Assets and Liabilities Are Important
Why is it important for a business to understand where its assets and liabilities stand at any given time? Knowing exactly what you have that is of value to the company by way of assets and consequently what the company owes over both the short and long term is going to be hugely important when it comes to helping you make decisions and adjustments moving forward. For instance:
- Track your spending. Seeing where your liabilities are for example can help you better comprehend where the company is spending its money and if that spending is worth it. You may not be aware of how quickly debt is accumulating; an increase in liabilities to this end could be a sign that it is time to slow down as far as spending goes.
- Pay down debt. Again, if the debt is accruing rather rapidly and you suddenly find yourself with a large number on the liabilities side of the balance sheet, you may want to try and pay down some of that debt. Keep in mind, in paying down debt you do still want to have enough cash on hand as far as reserves to handle anything unexpected that may come up. So think carefully about whether or not it makes sense to pay off a debt.
- Invest your money. Depending on where assets and liabilities stand, you may realize that you have excess cash on hand. This could be a good time to save and/or invest that money. You might think about reinvesting into the business or purchasing real estate that could be used for future expansion among other types of investments.
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