Assets, liabilities, and owner’s equity are the main categories of a company’s balance sheet. Understanding these topics is the precursor to comprehending the sources of a firm’s revenues and expenses. A firm grasp of these balance sheet components allows stakeholders to identify approaches to improve corporate performance.
Owner’s equity is the capital invested or committed by the founders or shareholders of a company. Let us assume an individual requires NGN 5 million to open a grocery store in Yaba, Lagos. The entire sum will be used to purchase goods, furniture and fittings, electricity, rent, and a few other essentials. If the individual has NGN 2.8 million only to invest, this is referred to as the owner’s equity. If he secures the balance of NGN 2.2 million by taking out a loan from a bank, this amount is a liability. Equity is also called net asset which is what you have left after paying all your debts. The fundamental accounting equation of Assets = Liabilities + Owner’s equity supports this.
Ordinarily, there are two ways you could finance a business, it is either by owner’s equity or debt. Most times companies are funded both ways, by the owner’s equity and by debts. Most companies borrow and do not use all their money for financing new expansion or a new product or subsidiary. You might be wondering and want to know why companies borrow when they have the cash? It is because when they borrow and they make a profit that exceeds the interest rate, they will have more cash flow, and have more profit. The more they borrow, the more profit they can make if the business succeeds.
Using the grocery store example above, your liability in running the grocery store is NGN 2.2 million which is your debt. When a company borrows to finance its operations, such borrowing is called liability. Liability is often calculated by subtracting the owner’s equity from the total assets (Liabilities= Assets-Owner’s Equity).
Assets are anything you can give in exchange for cash flow, it could be a property, a car, a skill, and education, some experience, some talents, some connections, relationships, or an inheritance that can be exchanged for cash flow. In business, an asset is a resource with economic value that an individual, corporation, or country owns or controls with the expectation that it will provide a future benefit. Assets include everything a company owns, it could be a piece of equipment, buildings, properties, or even intellectual properties. Interestingly in business, assets include not just what you own but also what you have borrowed called debts. Therefore, the accounting equation explicitly states that the asset of a company is the summation of the owner’s equity and the liabilities. (Assets=Owner’s equity + Liabilities).
These three items are a major part of the balance sheet of a company which can be found usually in the company’s annual report and can be used to calculate important financial ratios that show the profitability, liquidity, solvency, and overall performance of the company over a given period.