The Asset to Liability ratio of businesses can help assess their profitability and scope for growth accurately. Information regarding this ratio can help prepare financial statements for a company.
Financial statements include the Balance Sheet, the Cash Flow Sheet, and the Statement of Income. One must have a clear understanding of assets and liabilities to prepare these statements.
In simple words, one can define Assets as everything that a company owns. Liabilities, however, refer to everything that a company owes to third parties, such as investors, debtors, and banks.
Assets and Liabilities are resources available to a company, which dictate its financial prowess. One might question, what are assets? To answer this question, we must focus on the ability of resources to generate revenue, or benefits in some way.
One can explain the relationship between assets and liabilities with the help of the formulae given below.
Liabilities=Assets- Owner’s Equity
1. What are Assets in Accounting?
Examples of Assets include Machinery, Land, Inventory, Cash, and its equivalents for a company. In the case of a person, it might refer to stock, land, houses, and other things that can generate cash when required, without any depreciation.
Assets are of several types, including Personal and Business Assets.
- Personal asset examples include Cash, its equivalents, certificates of deposits made, property, boats, jewelry, and vehicles. Liabilities are subtracted from Assets to obtain the net worth of an individual. A positive net worth indicates that the accumulated value of assets is more than liabilities.
- Business Assets examples include things that can help with production or help the company grow, including property, machinery, and inventory. Intangible entities like royalties and patents owned by a company also fall under this category.
When listed on a balance sheet, assets fall into two categories, Current and Fixed Assets.
Current assets include resources that are easy to convert into cash within a fiscal year. Companies utilize their current assets to fund their daily expenses and include Cash and its equivalents, Marketable Securities, Inventory, and Accounts receivable.
Fixed Assets refer to assets that exist physically, and tangible asset examples include the ones listed under Property, Plant, and Equipment on a balance sheet. Some intangible assets include Copyrights, Licenses, Patents, and brand names.
2. What are Liabilities in Accounting?
Liability refers to something that the company owes to third parties, such as investors and debtors. When explained in simpler terms, liabilities refer to an obligation between two parties that is paid partially.
They can include future services that are to be provided by the business to other entities, or incomplete transactions that have been carried out in the past, still falling under an obligation.
Liabilities are further categorized as current and non-current liabilities. Current liabilities are the ones that have the possibility of concluding within 12 months. On the other hand, Non-current liabilities refer to liabilities that take more than 12 months to clear.
Examples of liabilities:
They include particulars like Bank debts, Mortgage debts, accounts payable (money owed to suppliers, debtors, and others). For businesses, employees’ salaries and retirement funds also come under liabilities.
Liabilities fund the big scale expansions of companies while making transactions between businesses easier.
Suppose Mr. X is a contractor in the construction industry who buys cement from a supplier by providing a 30% down payment for all the products he has bought, and the rest is to be paid post the completion of the project. The rest of the amount to be paid will be included in Mr. X’s liabilities.
Liabilities and Assets differ in many ways. One can understand the differences starting on a simpler note by contemplating the fact that assets provide economic benefits in the future, while liabilities present an obligation to be fulfilled.
One must also consider the fact that several assets present the possibility of depreciating value in the future. On the other hand, liabilities do not possess chances of depreciation. If explained in Layman’s terms, assets generate cash flows for companies, while a liability causes outflow of finances.
Comparison based on the nature of balance suggests that every asset is bound to possess a debit balance, while liabilities provide a credit balance.
How do Assets and Liabilities help assess businesses of various scales?
One can paint a pretty accurate picture about a company by carefully analyzing its Assets and Liabilities. One of the many ways used to assess businesses includes the calculation of the Debt-to-Asset ratio.
One can calculate this ratio by analyzing the balance sheet of a company. It provides information regarding the percentage of assets bought with borrowed money.
A higher debt-to-asset ratio can lead to difficulties for the company regarding borrowing more money. One will find it easier to understand the implication of this ratio by considering a scenario.
A 60% debt-to-asset ratio of a company means that debts have financed 60% of the assets. This further implies that equities have only provided funding for 40% of the company’s assets.
Usually, companies with a high debt-to-asset ratio possess higher risks of insolvency and bankruptcy. Thus, a thorough analysis of a company’s assets and liabilities can help the management improve its financial structure.
How are Assets and Liabilities listed on a Balance Sheet?
Balance sheets are one of the three financial statements that can convey the financial performance of a company. A typical balance sheet would include two columns, listing out the particular assets held by a company on the left and their liabilities on the right column.
Assets are listed according to the ease of conversation from top to bottom. Current assets such as Cash, Equivalents of Cash, certificates of deposit, accounts receivable are kept first on the list. Prepaid expenses and insurance premiums also come under current assets.
Fixed assets come next, and they are the ones that generate revenue. These assets often face depreciation, including furniture, machinery, and modes of transportation used by the company(cars and trucks).
Liabilities are listed on the column to the right and are arranged in an order of decreasing urgency for payment, keeping current liabilities first. Suppose a business has accounts payable within 30 days and notes payable to a bank within 90 days. Accounts payable are listed first in the balance sheet, followed by the notes payable, and so on.
Further on, salaries and wages amount to be paid within a year are listed under the same. Long-term liabilities are listed below the current ones and include obligations and amounts that are payable after a year.
One can conclude from all the examples that have been brought to attention that assets are something that a company or business owns, while liabilities refer to services and compensation owed to third parties. Businesses need to keep these factors under regular supervision to avoid financial imbalances.
Better financial management can help companies grow and expand their horizon. Careful analysis of the assets and liabilities of a company provides insight into its financial standings. This facilitates investors and interested parties to make informed decisions regarding investments in a company.
However, it can sometimes get hectic for businesses to accurately regulate their assets and liabilities on paper, which can lead to imbalanced inferences regarding finances.
This is something that ProfitBooks is good at, as its user-friendly software allows you to keep your financial stats updated. This can allow you to make informed decisions regarding your business.