Assets, liability, and equity are the three components of a balance sheet. In order for the balance sheet to be considered balanced, assets must equal liabilities plus equity. These three categories allow business owners and investors to evaluate the overall health of the business, as well as its liquidity, or how easily its assets can be turned into cash.
Assets mean anything that a company possesses. This doesn’t necessarily mean that the company owns those things, simply that they have them in their possession.
At the top of the assets list on the balance sheet are anything that could be easily liquidated. This includes cash and other cash equivalents.
These items are usually followed by assets that the company is owed, but are not in their possession yet. Think accounts receivable where outstanding invoices and payments will translate to cash in the coming months.
Toward the bottom of the asset list are Property, Plant, and Equipment. These are the assets that would be difficult to liquidate quickly. You may have several delivery vehicles in your possession, for example.
The reason assets are subdivided into categories based on how easily they can be liquidated is to show anyone interested in your books how able you are to pay off debts and liabilities. If all of your assets are tied up in property and equipment and you have very little cash on hand, that could signal potential cash flow problems.
Remember that a balance sheet is meant to be a snapshot of your company at any given time. It shows ratios that can help you decide what the right balance of asset types and assets to liabilities and equity is for your company.
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Let’s get those books in order.
Liabilities mean everything that the company owes to other people. Think accounts payable and credit card balances. This could also include health insurance liability or benefits. Basically, your liabilities show you everyone you’ll need to pay money to coming up.
This is where having a thorough understanding of your assets is helpful. If your liabilities have gone up considerably, ask yourself if you currently have enough easily-accessible assets like cash to pay them. If not, you’ve got some decisions to make to increase your cash flow.
Equity shows the assets that the company owns outright. If you were to sell all your assets and pay off your liabilities, the owner’s equity would be what’s left. It shows retained earnings and, if the company is publicly traded, stock information. It’s the exact opposite of liabilities because it shows you what is yours to keep as a company.
There’s no perfect balance of liabilities and equity. It may depend on the type of business you’re building or the stage you’re in. Startups with funding may have a lot of cash, but they also usually spend like crazy, driving up their liabilities in the name of future growth and long-term equity. Small businesses looking for steady growth, on the other hand, may pay close attention to their cash assets so they can plan for big purchases in the future.
Ready to gain even more accounting knowledge? Check out our list of the 37 accounting terms business owners will want to know.