In simple terms, assets are what a company owns, and liabilities are what a company owes to other parties. Assets put money into a company, whereas liabilities take money from the company. Assets increase the value of a company’s equity while liabilities decrease it. If the number of assets owned by a company is much greater than the liabilities, the business’s financial health is strong. If vice-versa is true, the company could be on the verge of bankruptcy!
Assets
Assets of a company/business help decrease its costs and increase revenue. A rise in assets spikes profits and generates a cash flow. The economic value of assets owned by a company/business means they can be exchanged or sold in the market. By definition, the assets of an organization are calculated using the following formula:
Total assets = Liabilities (accounts payable) + Owner’s equity
Types of assets
Assets are broadly classified into three different categories. They are:
- Convertibility: Convertible assets are further divided into Fixed assets and Current assets.
- Fixed assets: These resources are difficult to convert into cash. Fixed assets include land, machinery, building, equipment, etc.
- Current assets: These resources can easily be converted into cash. Examples of current assets include cash equivalents, stocks, securities, etc.
- Physical existence: Assets can be further divided into Tangible and Intangible Assets.
- Tangible assets: Assets with a physical existence are classified as tangible assets. Examples of this asset class include buildings, equipment, machinery, etc.
- Intangible assets: Assets without a physical existence are classed as intangible assets. Examples of this class of assets include copyrights, permits, trade secrets, etc.
- Purpose of use: Assets can further be classified by the purpose of their use into Operating and Non-operating assets.
- Operating assets: These assets generate revenue and keep daily operations running. Operating assets include cash, building, machinery, equipment, etc.
- Non-operating assets: Although non-operating assets are not used for day-to-day operations, they generate substantial revenue. Examples of non-operating assets include short-term investments, vacant land, etc.
Examples of assets owned by a company/business
- Cash
- Inventory
- Investments
- Machinery
- Office equipment
- Real estate
- Company-owned vehicles
Liabilities
A company’s liability is constituted by all its payables to different accounts/parties. The lesser the liabilities, the better it is for the company/business. Liabilities play a crucial role in a company’s financial expansion and smooth operation of everyday commercial processes. By definition, the liabilities of an organization are calculated using the following formula:
Total liabilities = Assets (account receivable) – Owner’s equity
Types of liabilities
Liabilities are divided into two different categories. They are:
- Internal liability: Examples of internal liabilities include capital, profits, salaries, etc.
- External liability: Examples of external liabilities include taxes, overdrafts, borrowings, etc.
Liabilities can further be classified into three different types:
- Current liabilities: The accounts under this category are usually short-term, payable within a year. Examples of current liabilities include bills, trade creditors, bank overdrafts, etc.
- Non-current liabilities: The accounts under this category are long-term, payable over a significant period. Companies typically take upon these to aid expansion or buy fixed assets. Examples of non-current liabilities include debentures, long-term loans, payable bonds, etc.
- Contingent liabilities: These liabilities may or may not occur depending upon the commercial entity involved in the process. Examples of contingent liabilities include claims against product warranty, lawsuits, etc.
- Bank debt
- Mortgage debt
- Money owed to suppliers
- Wages owed
- Taxes owed
The importance of a healthy relationship between Assets and Liabilities
- A good ratio between the assets and liabilities of a company results in a healthy profit. Additionally, the ratio of assets and liabilities dictates the liquidity ratio of a company. The liquidity ratio increases a company’s ability to convert assets into cash equivalent. By definition, the liquidity ratio depends on the following formula:
Current ratio = Current Assets / Current Liabilities
- A higher ratio means the business or the company is thriving and its capability to pay off debt is good. Similarly, a company’s capability to pay off short-term liabilities is decided by the Acid-test ratio. By definition, the Acid-test ratio has the following formula:
Acid-test ratio = Current assets – inventories / Current liabilities
- The cash ratio determines the ability of a company to pay off short-term liabilities with the help of cash flow. By definition, the Cash ratio has the following formula:
Cash ratio = Cash and Cash equivalent / Current liabilities
- Knowing one’s assets and liabilities also helps a company realize its debt ratio, an indicator of the current outstanding debt.
Debt ratio = Total Liabilities / Total Assets
- Assets and liabilities also help a company calculate the value of the existing capital or owner’s equity. It is calculated using the following formula:
Owner’s equity = Total assets – Total liabilities
Conclusion
A company’s assets and liabilities are of utmost importance when measuring its liquidity, debt repayment capability, and profitability. Hence, before investing in a company, it is essential that investors thoroughly study the assets and liabilities of the company.
