Assets vs. Liabilities: The Complete Breakdown
An important task for small business owners is managing financial resources. You need to have a clear understanding of the important elements of the financial statement to make good business decisions.
Assets and liabilities are two critical elements that help you evaluate the financial position of your business. A thorough understanding of these basic terms is important to ensure that you make the right business decisions.
Business Assets: An Overview
Assets in the accounting content refer to everything of significant value that is owned by a business. In the financial statement, assets are shown on the left side or the top of a balance sheet.
Balance Sheet: Explanation, Components, and Examples
Assets owned by a business can be divided into two categories. These include the current and fixed assets.
Current Assets
Current assets refer to assets that can be converted into cash relatively quickly. Examples of current assets include:
- Inventory
- Cash
- Accounts Receivable
Businesses that have high current assets will be in better financial shape. High current asset means that the business won’t likely have to rely on an external source of financing to meet business expenses.
Fixed Assets
Fixed assets have a life of more than a year. Examples of fixed assets include:
- Furniture & Fixture
- Computer & Equipment
- Land
- Company Vehicles
Companies spread the cost of the fixed assets over the useful life of the asset. The depreciation expenses will be recorded in the profit and loss statement up till the end of the estimated useful life of the asset.
Suppose that you have bought office equipment for $5,000. The estimated useful life of the fixed asset is 10 years. You will record the fixed asset in the balance sheet and calculate yearly depreciation expenses. The depreciation expenses are calculated by dividing the cost of the fixed asset by the useful life of the asset. In this case, the yearly depreciation expense amounts to $500.
Tangible and Intangible Assets
Assets can also be divided into tangible and intangible assets. Tangible assets refer to physical assets of value that can be touched. These include land, vehicles, furniture, computers, and equipment.
In contrast, intangible assets don’t have a physical presence. The assets have a financial value that can be calculated. Examples of intangible assets include goodwill, brand recognition, and copyright.
Business Liabilities: An Overview
Liabilities refer to anything owed by the business to another. The liabilities are generally written on the right side or lower part of the balance sheet. Examples of liabilities of a company include:
- Loan
- Account Payable
- Salaries Payable
Liabilities similar to assets can be divided into current and long-term liabilities.
Current Liabilities
Current liabilities refer to the liabilities that have to be paid within the year. Examples of current liabilities include short-term loans, credit lines, and accounts payable.
Long-term liabilities refer to the amount due after a year. Mortgage and loans due after a year are examples of long-term liabilities.
Assets and Liabilities: Accounting Equation
Assets and liabilities can be reviewed to find out the worth of the business. Business owners can determine the strength of the business by looking at the net assets and liabilities.
The accounting equation can be used to calculate the equity or net worth of the business.
Net Assets – Net Liabilities = Equity
In the above formula, equity is also known as capital. The higher the net assets and lower the liabilities, the higher will be the equity of the company. Negative equity means that the company is facing financial difficulties.
Business owners should review the net equity regularly. The business equity should increase over time. It is important to ensure that the assets of the business increase more than the liabilities of the company.
How Assets and Liabilities Relate to Business Performance
Assets and liabilities reflect the performance of the business. Assets such as machines and equipment help a business to improve productivity. Inventory also helps a business to generate profit. These assets provide benefits to the company in the present and the future.
Liabilities refer to the obligations of the company. Liabilities such as accounts payable and salaries payable refer to services that are yet to be performed.
A company should have more assets than liabilities. The assets of the company should be sufficient to pay back the loans. If the liabilities are more than assets, a company will have difficulty paying back the debts.
Excess liabilities are not always bad for a firm. If the firm takes a loan to improve its productive capacity, it will provide benefits in the future. The assets will improve the capacity of the firm to produce more or produce goods at lower costs. This means that liabilities that finance the growth of the company are not bad for the company.
Examples of Assets and Liabilities
The following examples will help you to fully understand the concept of assets and liabilities.
Example 1
Suppose that you buy a property for your business. The property is an asset that you will own for a long time. Therefore, the cost of the property will be spread over several years.
If you mortgage the property, it will be represented as a liability in the books. The reason is that a mortgage is a loan that is due after a specified period.
Example 2
Let’s suppose that you decide to buy a car for business purposes. The car represents an asset with the cost spread out over several years.
The accounting treatment will be different if you lease a vehicle. The lease payments represent a business expense. The lease payments are recorded in the profit and loss statement of the company.
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