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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.
Plus, if you need a 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 will still balance out in your company’s overall finances.
- Assets are quantifiable things — tangible or intangible — that add to your company’s value
- Liabilities are what your company owes to others, whether that’s an investor or a bank that issued a loan
- Equity is everything left when you subtract liabilities from assets, and it represents the owners’ value in the company
- To balance your books, the accounting equation says assets should always equal liabilities plus equity
What are assets, liability and equity?
Assets are things that add to your company’s overall value. That could be cash, tangible assets like equipment or intangible ones like your reputation in the community. Liabilities are what you owe to others, like investors or banks that issue your company a loan. Equity is what’s left and 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
Per the accounting equation:
assets = liabilities + equity
Remember, accounting is all about balance — they call it “balancing your books” for a reason.
Let’s say your company makes $20. That’s an asset. But that’s not all. It’s also either liability or equity. If Bank Y lent you that $20, it’s a liability you need to pay back. If that $20 was net profit, it goes toward the owner’s equity in the business.
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.
This is anything your company has to which you can attribute a positive dollar amount. That could be:
- Company vehicles, equipment or real estate you own
- Inventory you have on hand
- Patents, copyrights and trademarks
- 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.
How to calculate total assets
To some extent, calculating total assets is as simple as adding up everything of value your company owns.
It might be tricky to attach dollar amounts to certain things. A little research could help clarify things. For example, if your company has a sizable social media following, you might use this calculator to arrive at a number to attribute to your asset.
To help you make the list of everything you should add together to arrive at total assets, think through:
- Liquid or near-liquid assets (cash, accounts receivable, inventory you could sell easily, etc.)
- Long-term assets (stocks, bonds, etc.)
- Tangible assets (equipment, real estate, vehicles, etc.)
- Intangible assets (company or employee reputation, etc.)
Liabilities represent financial obligations that your company has to other people or entities. That includes:
- Short and long-term 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 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 folded and liquidated its assets today. The company would need to pay back its liabilities. Then, whatever’s left would get distributed among the owners. That’s their equity.
Owner’s equity formula
To calculate an owners’ equity, you total up a company’s assets and subtract its liabilities. In other words:
owner’s equity = assets – liabilities
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. If you take out a new loan, for example, that added liability reduces owners’ equity.
Adjusting the key components of the accounting equation comes down to using the net change formula:
net change = current period’s value – previous period’s value
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.
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
An asset adds value to your business, whether cash, equipment, accounts receivable or something else to which you can attribute a dollar amount. A liability is something your company owes, from a loan to an outstanding invoice. Equity is what’s left when you subtract liabilities from assets, symbolizing the owner’s value in the company.
Assets represent the resources your business owns and that help generate revenue. Liabilities are considered the debt or financial obligations owed to other parties. Equity is the owner’s interest in the company. As a general rule, assets should equal liabilities plus equity.
- Assets. Anything that you can attribute a dollar amount to that adds value to your business
- Liabilities. The debt your company owes to other entities or individuals
- Equity. The remaining amount, which is owed to the owners
To create a balance sheet, assets should equal liabilities plus equity (assets = liabilities + equity). Initially, a spreadsheet for each category can help you keep tabs on these key numbers. As you grow, you may want to leverage accounting software, an accountant/bookkeeper or both.