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What are assets?
Assets are anything valuable that your company owns, whether it’s equipment, land, buildings, or intellectual property.
When you look at your assets, you’re trying to answer a simple question:
"How much do I have?"
If it has value, and you own it, it’s an asset.
Some common asset types include:
- Accounts receivable: any payments that your clients and customers owe you.
- Cash: the money you have in your business bank account.
- Inventory: any goods you have in stock that you intend to sell.
- Property and equipment: any buildings or tools that you need to operate your business.
Assets are generally divided into two categories:
- Current assets: cash and anything that can be converted into cash within a year (like inventory, for example).
- Fixed assets: Things like land, trademarks, and the value of your “brand.”
What are liabilities?
Your liabilities are any debts your company has, whether it’s bank loans, mortgages, unpaid bills, IOUs, or any other sum of money that you owe someone else.
When you look at your accounting software or spreadsheets and look at your liabilities, you’re asking:
"How much do I owe?"
If you’ve promised to pay someone in the future, and haven’t paid them yet, that’s a liability.
Some popular examples include:
- Accounts payable: payments you owe your suppliers.
- Bank loans: the principal you owe investors
- Salaries and wages payable: what you’ve agreed to pay your employees in the future, but haven’t paid out yet.
Again, there are two main kinds of liabilities.
- Current liabilities: debts you owe within the next 12 months.
- Non-current liabilities: long-term debt that ranges beyond 12 months.
Combine them, and you get your total liabilities.
What is equity?
Once you’ve figured out how much you have and how much you owe, it’s natural to ask one more question:
"How much is left over?"
That’s what looking at your equity tells you: how much value is left over once you’ve totalled up everything valuable that you have, and subtracted everything you owe to your creditors. For a small business owner, equity is the net worth of your business.
Put another way: when you take all of your assets and subtract all of your liabilities, you get equity.
For a sole proprietorship or partnership, equity is usually called “owners equity” on the balance sheet. In a corporation, equity is shareholders’ equity.
The difference between assets, liabilities, and equity
Category Description Asset
The equity equation
The equity equation (sometimes called the “assets and liabilities equation”) is as follows:
Assets – Liabilities = Equity
The type of equity that most people are familiar with is “stock”—i.e. how much of a company someone owns, in the form of shares. But that’s not the only kind of equity.
Other examples include:
- Preferred stock: like regular stock, but it entitles you to some extra perks. (People who hold preferred stock usually have first dibs on profits.)
- Capital: whatever is left over from the money that the company’s founders initially invested in the business.
- Retained earnings: any profits that owners decided to keep in the company for future spending, rather than pay out to themselves.
The most important equation in all of accounting
Let’s take the equation we used above to calculate a company’s equity: Assets – Liabilities = Equity
And turn it into the following: Assets = Liabilities + Equity
Accountants call this the accounting equation (also the “accounting formula,” or the “balance sheet equation”).
It might not seem like much, but without it, we wouldn’t be able to do modern accounting. It tells you when you’ve made a mistake in your accounting, and helps you keep track of all your assets, liabilities and equity.
The accounting equation in action
In order for the accounting equation to stay in balance, every increase in assets has to be matched by an increase in liabilities or equity (or both).
If the accounting equation is out of balance, that’s a sign that you’ve made a mistake in your accounting, and that you’ve lost track of some of your assets, liabilities, or equity.
Example #1: Starting up a business
Let’s say you and your friend Anne get together and start a small business. You have a killer idea for an app: it will use cutting edge artificial intelligence technology to automatically call and order coffee from the nearest cafe.
You both agree to invest $15,000 in cash, for a total initial investment of $30,000.
After you deposit the $30,000 in cash (an asset) into your company’s business account, the accounting equation for your business looks like this:
Assets
$30,000 in cash
=
Liabilities
$0
+
Equity
$30,000 in stock (you and Anne)
Now let’s say you spend $4,000 of your company’s cash on MacBooks.
For the accounting equation to remain in balance, we need to not only decrease the cash account by $4,000, but also increase the equipment account by $4,000:
Assets
$26,000 in cash
$4,000 in equipment (MacBooks)
=
Liabilities
$0
+
Equity
$30,000 in stock (you and Anne)
Example #2: Taking out a loan
Now let’s say you and Anne take out a $10,000 bank loan (a liability) to pay for expensive standing desks for your three employees. (Anne thinks they’re too expensive, but you think it will improve employee morale.)
Right after the bank wires you the money, your cash and your liabilities both go up by $10,000.
The accounting equation for your company now looks like this:
Assets
$36,000 in cash
$4,000 in equipment (MacBooks)
=
Liabilities
$10,000 in loans
+
Equity
$30,000 in stock (you and Anne)
A few days later, you buy the standing desks, causing your cash account to go down by $10,000 and your equipment account to go up by $10,000.
The accounting equation for your company now looks like this:
Assets
$26,000 in cash
$4,000 in equipment (MacBooks)
$10,000 in equipment (Standing desks)
=
Liabilities
$10,000 in loans
+
Equity
$30,000 in stock (you and Anne)
Notice how your company’s total assets have increased by $10,000, and your liabilities have also increased by $10,000?
Unlike example #1, where we paid for an increase in the company’s assets with equity, here we’ve paid for it with debt.
The balance sheet
All this information is summarized on the balance sheet, one of the three main financial statements (along with income statements and cash flow statements).
Balance sheets give you a snapshot of all the assets, liabilities and equity that your company has on hand at any given point in time. Which is why the balance sheet is sometimes called the statement of financial position.
Here’s a simplified version of the balance sheet for you and Anne’s business.
Balance Sheet Anne & Company Inc.
Why does all of this matter?
Assets, liabilities, equity and the accounting equation are the linchpin of your accounting system.
They tell you how much you have, how much you owe, and what’s left over.
They help you understand where that money is at any given point in time, and help ensure you haven’t made any mistakes recording your transactions.
Balancing assets, liabilities, and equity is also the foundation of double-entry bookkeeping—debits and credits.
Without understanding assets, liabilities, and equity, you won’t be able to master your business finances. Debt could pile up even while cash is coming in fast. But armed with this essential info, you’ll be able to make big purchases confidently, and know exactly where your business stands.
