What are Assets and Liabilities? Once you understand how the terms assets and liabilities are used in business, you can use that knowledge for your benefit in your personal life as well. In accounting, assets and liabilities are terms that you will find on the balance sheet. What you own is on the left: resources. What you owe is on the right: liabilities and value.
Let’s work through some examples of assets and liabilities. What might be said about a machine that the organization purchased to create merchandise that it is selling? This is a substantial fixed resource, something that the organization claims and that has actual structure. How about we put that in resources on the left.
Basic Elements of Accounting
What about Accounts Receivable? These are solicitations shipped off the client, which the client has not paid at this point. This is a resource also: we own the option to gather the cash for the labor and products we have conveyed. What about Accounts Payable? These are solicitations gotten from a provider, which the organization has not paid at this point. This is a liability: we owe money to the supplier. How about we put that in resources on the left.
Cash is a financial asset. Cash is very liquid, in most cases you can use it immediately to pay your obligations. Inventory. Inventory is an asset as well. These are products that we own, and plan to sell. A loan agreement, a borrowing, debt. The company owes money to the bank. This is a liability. We now have many of the elements of a balance sheet for a company. There is one more very important element, which fits in the bottom right corner of the balance sheet: equity.
Equity is the shareholder capital. You can calculate it by taking the total value of the assets minus the total value of the liabilities. Now that you understand the picture of assets, liabilities and equity on the balance sheet, let’s think of the dynamics going on in a company. A company will try to generate a return on assets. If the revenues generated (from selling goods and services) are bigger than the expenses (such as labor, materials, and depreciation of manufacturing equipment), then the company generates a profit.
Return on Assets
Return on Assets relates the amount of profit made to the assets needed to generate that profit. Some companies need very few assets to generate a substantial profit. Other companies may need a lot of assets to generate only a modest profit. Increasing ROA is generally a good thing. On the liability side, having debt generates a cost of borrowing. The amount of interest that a company pays depends on the amount borrowed and the interest rate.
If a company improves its financial health, its cost of borrowing tends to go down. In general, it is good to have a Return On Assets that far exceeds the cost of borrowing. Let’s apply what we learned about assets and liabilities to assets and liabilities in your personal life. What if you own a house? That’s an asset. However, if you rent a house as a tenant, then you wouldn’t put the house on your balance sheet as an asset, as you don’t own it. What if you own a car? That is an asset as well. If you lease a car, you wouldn’t put the car on your balance sheet as an asset, as you don’t own it. What about cash? That is an asset. Unpaid creditcard bills? A liability. A portfolio of stocks? An asset. A loan agreement with a bank (for example the mortgage loan on your house)? A liability.
There is one more element, which fits in the bottom right corner of the balance sheet: equity. You can calculate it by taking the total value of the assets minus the total value of the liabilities. Within the assets in your personal life, there can be items that we call (potential) “earning assets”: cash in a savings account that pays you interest, and stocks in an investment portfolio that pay a dividend or go up (or down!) in value.
Just like companies monitor their cost of borrowing closely, you should also keep track of your cost of borrowing on various types of debt you might have outstanding. Chances are that the unpaid creditcard bills carry the highest interest rate, and therefore should get the highest priority in paying down! So what is financial wealth in somebody’s personal life? A lot of people mistake wealth for assets. We tend to think that the more assets somebody has, the wealthier that person is.
But what if that beautiful yacht as well as that fancy sports car are all debt-financed? Assets increase (the person owns more), but liabilities also increase (the person owes more). The more debt you add, the more fragile you get. The true measure of financial wealth, which is often not visible to the outside world, is the amount of equity that somebody has! Assets minus liabilities. Looking at somebody’s assets without knowing how they are financed, might be deceiving. It might actually be the person with the smaller house and the older car, but with very few or even no liabilities, that is the more financially wealthy!