In bookkeeping and accounting, assets and liabilities are reflected on a company’s balance sheet. The easiest way to think about Assets are as things your company or firm owns, and liabilities are the things you owe to other people. As per the U.S. Small Business Administration, and GAAP, your business’s assets should be more than its liabilities.
However, both assets and liabilities play a vital role in determining your business’s profitability and long-term feasibility. Moreover, companies should be focused on managing both assets and liabilities efficiently.
We know Assets increase business equity and add value, meanwhile Liabilities decrease your company’s equity and value. The more assets than liabilities, the stronger is the financial position of your company.
But if your liabilities are larger than your assets, you’re risking going out of business. Hence, it is crucial in accounting for service-based businesses to evaluate assets and liabilities efficiently as they can give us important information on a companies’ finances.
Types of Assets
Assets are divided into tangible and intangible assets.
Tangible assets are assets you can touch, for example, vehicles and land. Intangibles are the ones that don’t have any physical presence but do add value to the company, for example brand recognition, proprietary software, contracts and copyrights.
Current Assets are assets that can be converted into cash in one operating cycle of a manufacturing process. For example, marketable securities, cash equivalents, short-term deposits, stock, etc. are all classified as current assets. Current assets are also known as short-term assets (think of them as highly liquid).
Fixed assets are the opposite of current assets. These are the ones that are difficult to convert into cash. They have a long commercial life and are deployed by the company for its operations. For example, building, land, equipment, machinery, trademarks, patents, etc. are fixed assets. Fixed assets are also known as long-term assets or hard assets.
Assets that are used for daily operations and for generating revenue are known as operating assets. For example, stock, copyright, goodwill, cash, machinery, etc. are classified as operating assets.
Un like operating assets these assets are not used for daily operations. However, they still help in generating revenue. Some examples include Income from fixed deposits, short-term investments, vacant land, etc. all are non-operating assets.
Types of Liabilities
Liabilities are divided into short-term and long-term liabilities. Let’s take a better look at them.
These are short-term liabilities that are due within one year from the balance sheet date. These are short-term in nature and are used for funding current assets. Sundry creditors, short-term bank borrowings such as overdraft, cash credit, advance payments received from clients, etc. are current liabilities.
Also known as deferred liabilities and fixed liabilities are long-term liabilities representing long-term finance. Any payment that is to be made after one year from the balance sheet is deferred liability for the company.
These are incurred to acquire fixed assets like plant and machinery, land, equipment, building, etc. and are repaid after a specific period. Debentures and long-term loans from banks are types of deferred liabilities.
These liabilities may or may not occur for a company during its operation. It is entirely contingent upon a particular set of situations. For example, lawsuits, claims against product warranty, loan guarantees, etc. are types of contingent liabilities.
It is mandatory for companies to mention the value of their contingent liabilities as a footnote in the balance sheet.
Balance Sheet Ratios
Once you have created your balance then you can start analyzing it even further using ratios, below are examples of some important and useful ratios all businesses of any size should be looking at:
Solvency Ratio (measures: companies’ ability to meet its debt obligations / long term)
These ratios are utilized to break down your firms’ cash, assets, and obligations. Through these ratios, you are trying to check whether your firm has enough assets and cash to keep working efficiently. The higher the ratio, the better-off your company is.
Quick Ratio (measures: companies’ ability to meet its short-term obligations. Think, short-term liquidity, it is more conservative than current ratio)
The quick ratio formula is liquid assets / current liabilities. Where Liquid assets are Cash and Cash Equivalents + Marketable Securities + Accounts Receivable.
This is an important ratio because it lets you measure your business ability to turn assets in to cash, which is then used to pay off liabilities (debts). Remember, the higher the Quick ratio is the better-off your company will be at paying off its debts.
Current Ratio (measures: companies’ ability to meet its short-term obligations / due within one year)
The current ratio formula is = Current Assets / Current Liabilities.
This ratio exhibits your private venture's capacity to take care of your short-term liabilities. A high ratio implies that your company can take care of short-term commitments successfully, while a lower ratio means your company will most likely have trouble paying off short-term debt, and this a red flag that all business owners need to learn how to spot.
As we know the accounting formula used calculate a companies’ net worth is:
Total Assets - Total Liabilities = Equity
Let’s remember that equity implies your company’s net worth. It is also known as your business’s capital. As a rule of thumb equity should always be positive, the higher the equity, the better for your business.
In bookkeeping and accounting business owners should periodically review their balance sheet to ensure liabilities are not growing faster than the assets, and they should do a deep-dive in to each one of the accounts as business owners can spot important information not found anywhere else in your financials.
It is also important to note that all business owners need to keep an eye on their balance sheet ratios as they give off alerts and warning signs that things need to be taken care of before they get worse.
If you are having a hard time understanding your company’s balance sheet or do not have these reporting capabilities, please do not hesitate to contact us. At Irazu Advisors we are here to help you on your path to growth and profitability.