Assets, Liabilities, Equity: What Small Business Owners Should Know
Assets, liabilities and equity are the three sections of every business’s accounting balance sheet. Assets are things your business owns. Liabilities are what your business owes to third parties. Equity is the value left over for the owners. This is summarized in the golden rule of accounting: assets equal liabilities plus equity.
An asset is a thing the business owns
The value of assets is recorded on the balance sheet at their price at the time they were acquired. Examples of asset categories include:
- Liquid assets: Cash and cash equivalents (liquid investments like stocks and bonds).
- Illiquid assets: Things that might be difficult to turn into cash quickly, like real estate.
- Tangible assets: Physical things like buildings, land, machinery, vehicles and inventory.
- Intangible assets: Non-physical things like patents and brand names.
- Current and noncurrent assets: Subcategories based on whether an asset is expected to convert to cash within a year (current) or not (noncurrent).
Asset depreciation
Asset depreciation is special accounting used for machinery and equipment. Because these large purchases generate value over several years beyond the year they’re purchased, a small portion called depreciation can be written off on taxes each year of their expected useful life.
The purpose of depreciation is to match the timing of costs with the timing of benefits to provide owners with a clearer picture of how well the business’s assets are performing.
A liability is a financial obligation
All types of debts are liabilities because the company is obligated to pay them back. Liabilities are an essential part of most companies’ financing for both day-to-day needs and long-term growth.
- Current liabilities: Anything due within a year, including accounts payable, interest and taxes payable and short-term business loans.
- Long-term liabilities: Anything to be repaid over the course of more than a year, including long term notes, bonds, leases and mortgages. It’s recommended to keep track of long term debt on a business debt schedule.
- Contingent liabilities: An obligation that might happen depending on the outcome of another event, such as a lawsuit. These aren’t usually included on a balance sheet because their size and timing is uncertain.
Equity equals assets minus liabilities
The balance sheet value, also called book value, of equity is calculated by the formula: equity = assets – liabilities. Theoretically it’s the value of an owner’s stake in the company after all debts are repaid. The book value of equity is calculated as the total of:
- The amount investors put into the company to buy common or preferred stock
- Less the value of any stock the company bought back, called treasury stock
- Plus retained earnings, which are the total profits of the company since inception minus all dividends ever paid.
However, the book value can be very different from the “market value” the owner would get if the company were liquidated or sold. For example, what if the value of the land, buildings, patents or brand names has gone up or down since the company acquired them? The market value has changed but the book value shows the old value when first purchased. A separate valuation analysis is required to understand what the company is really worth now.
The main accounting equation
The main accounting equation is: Assets = Liabilities + Equity.
The balance sheet reflects this “balance” between assets on one hand and liabilities plus equity on the other. The concept is that everything the business owns (assets) was paid for by either a lender (liability), an owner (common or preferred stock) or previous profits (retained earnings.)
This means that the recorded value of each asset is balanced by the recorded value of the liabilities or equity that paid for it. Here are three examples:
- An asset paid for with a liability: Your business has $10 cash, but you borrowed it from George. The $10 cash asset balances the $10 loan liability.
- An asset paid for with stockholders equity: You invested $100 in your business in exchange for common stock; the business uses that money for buying equipment. The $100 equipment asset balances the $100 in common stock equity.
- An asset paid for with profits: Your business earned a $5 profit, which you put into a checking account. The $5 cash asset balances the $5 in retained earnings equity.
Why it’s important to track assets and liabilities
Tracking assets and liabilities is an important part of managing your finances. They tell you what you own and what you owe. This information is also needed to calculate financial performance metrics like return on assets. Additionally, all prospective lenders and investors will want to see a current balance sheet.
Having up to date information at your fingertips will help you with critical business needs such as:
- Cash planning. A traditional rule of thumb is that current assets should equal or greater than current liabilities.
- Getting a loan. Every lender needs to know how much you already owe before they extend credit.
- Collecting from customers. Your accounts receivable asset tells you how much you’re owed by customers so you can pursue collections.
Other formulas for assets, liabilities, equity
Other formulas to know include:
Owner’s equity formula
The owner’s equity formula is the main accounting equation switched around: Equity = Assets – Liabilities.
The owner’s equity formula highlights the fact that the value of equity depends on the value of assets. If the market value of the assets changes, the market value of the equity will change, even if the balance sheet hasn’t.
Net change formula
The net change formula is: Net Change = New Value – Old Value.
Net change just means the change in value over time. For example, if a stock is worth $30 in January and $50 in March, the net change is $20.