What Are Assets, Liabilities and Equity?

Business owners should keep a finger on the pulse of three key components: their business assets, liabilities and equity. Knowing the total of each and ensuring that those numbers crunch as they should lays the foundation for good accounting. It can inform strategic business decisions and even prevent fraud.

To balance your books, the accounting equation says assets should always equal liabilities plus equity. If you need a business loan or line of credit, understanding the relationship between assets, liability and equity is key. Taking out a loan means adding to your liability, and you need to be sure that it will still balance out in your company’s overall budget.

What are assets, liability and equity?

Assets are items that add to your company’s overall value. That could be cash, tangible assets like equipment or intangible ones like intellectual property. Liabilities are what you owe to others, like vendors or banks that issue your company a loan. Equity is the amount left when you subtract liabilities from assets, and it represents the owner or owners’ stake.

When it comes to accounting, you need to make sure what you have in assets balances with your liabilities and owner equity. To do that, you use the accounting equation.

What is the accounting equation?

The accounting equation is:

The accounting equation states that your business’s assets should always balance with its liabilities and equity. This equation forms the double entry accounting system, meaning that every transaction for your business will result in a double entry in your books.

Let’s say your company generates $20. This cash is an asset, but it’s also either a liability or equity. If Bank Y lent you that $20, it’s also a liability you need to pay back. You would enter this transaction as both an asset and a liability, keeping your books balanced.

Examples of assets, liabilities, equity

Let’s look at each individually to help you get a better feel for how all of this should break down at your company.

Assets

Assets are anything your company has to which you can attribute a positive dollar amount. That could be:

• Cash
• Company vehicles, equipment or real estate you own
• Inventory you have on hand
• Patents, copyrights and trademarks
• Investments
• Accounts receivable

In some instances, you might be able to quantify less tangible assets, like your company’s positive reputation in your community or an individual employee who has specific expertise.

Liabilities

Liabilities represent financial obligations that your company has to other people or entities. That includes:

• Business loans (including interest and known fees)
• Accounts payable
• Equipment financing
• Real estate leases/mortgages
• Notes and bonds payable
• Dividends due to owners/shareholders
• Taxes (due in this tax year or deferred)

You should also include contingent liabilities or liabilities that might land in your company’s lap. This could include the cost of honoring product warranties or potential lawsuits.

Equity

Equity is the owners’ value in the company. That could be an individual owner — as with a sole proprietorship — or a large group, like shareholders in a publicly traded company.

You can think about equity in terms of what would happen if the company went bankrupt and liquidated its assets today. The company would need to pay back its liabilities. Then, the equity left would get distributed among the owners.

Owner’s equity formula

To calculate an owners’ equity, you total up a company’s assets and subtract its liabilities. In other words:

For example, if a company with five equal-share owners has $1.2 million in assets but owes $485,000 on a term loan and $120,000 for a semi-truck it financed, bringing its liabilities to $605,000. Their equity would equal $595,000 ($1,200,000 – $605,000), or $119,000 per owner.

This usually differs slightly from the market value of the company. Specifically, it’s usually lower. That’s because market valuations often factor in aspects — from intellectual property to expected future returns — that you don’t include in the owner’s equity formula.

Net change formula

Most company’s assets, liabilities and equity aren’t fixed. You will need to periodically adjust your calculations to reflect the current values and debts you have. If you take out a new loan, for example, that added liability reduces owners’ equity.

If you know the initial accounting equation for your business, you can adjust the numbers based on the net change formula:

Let’s say your company had $7,000 in inventory last quarter but has $5,000 in inventory now. To find the net change, you subtract the previous period’s value ($7,000) from the current value ($5,000) to arrive at a net change of $2,000. That means you should have $2,000 less as you total your assets.

How do assets, liabilities, and equity affect business financing?

A company’s assets, liabilities and equity can impact a lender’s view of your business’ financial health and ability to repay debt. A lender will review these factors to assess financial stability and determine how much of a risk it may be to lend money to your business.

A company with many existing liabilities, for instance, may not be able to keep up with additional debt payments. Additionally, a business that has very few assets to provide collateral for a loan in the event of defaulting on the debt may also be viewed as a higher lending risk.

Bottom line

Assets, liabilities and equity are important factors that determine the health of your business. Before applying for a small business loan or line of credit, make sure your balance sheet is in order because lenders will look at it to see that you can repay your debt. To keep the books at your company balanced, your assets should always equal the combined total of your liabilities and owners’ equity.

Frequently asked questions

• How does a balance sheet help you analyze information about business assets, liabilities and equity?
  

  A balance sheet is a key financial document where you can list out all company assets and tally their value, along with listing and tracking all liabilities. Similarly, a balance sheet is used to track your equity, by subtracting liabilities from assets.

  Organizing all of this information on a balance sheet helps you gain a clearer understanding of your business’ overall financial standing and, using that information, make any adjustments needed to your financial strategy or business operations.

• Why do assets and liabilities matter to a business?
  

  Assets and liabilities provide an indication of your businesses’ financial health. It is important to understand how much you have of each and know whether your business is solvent, meaning you have more assets than liabilities and are able to pay your debts.