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What are Assets and Liabilities?
Both assets and liabilities tend to play a vital role when it comes to ensuring the profitability of a business or its long-term viability. The key to ensure the same depends on how well a company can manage them effectively. Further, to achieve satisfactory outcomes, individuals who have to deal with assets, as well as liabilities regularly, must learn about these aspects in detail.
In a broader sense, all receivables are categorised as assets while the payables are categorised as liabilities. Another way to look at them is by segregating them based on profit and loss. For instance, the investments via which profit or income is generated are typically put under the category of assets, whereas, the losses incurred or expenses paid or to be paid are considered to be a liability. At a glance, the best examples of assets and liabilities would comprise cash and bank debt, respectively. Now, let’s take a detailed look at the two.
The term ‘asset’ signifies all kinds of resources that help generate revenue as well as receivables. Assets are resources which often help to reduce expenses, enhance profitability and generate robust cash flow as they help convert raw materials or can be converted into cash or cash equivalents. Further, being of economic value, they can be quickly sold or exchanged. Notably, such resources are reported on the left side of the Balance Sheet that is maintained by any entity involved in commercial practice.
Generally, the sum of total liabilities and equities owned helps compute the value of assets. Consequently, it can be said –
Formula: Total assets = Liabilities (accounts payable) + Owner’s equity
The term liability signifies all types of account payables. It can further be defined as a financial obligation that individuals must meet. Usually, the liabilities tend to play a significant role when it comes to financing expansion or ensuring smooth processing of everyday operations of commercial practices.
Further, depending on the type of a company, such liabilities can either be limited or unlimited. In the case of the former, owners are not entirely obligated to compensate or pay off for the venture’s liability, whereas in the latter, the resulting liability is solely the responsibility of the owners. The obligations of a commercial entity are reported on the right side of the Balance Sheet.
The difference between total assets and owner’s equity helps compute the value of existing liabilities. The same can be expressed as –
Total liabilities = Assets (accounts receivable) – Owner’s equity
Different Types of Assets and Liabilities?
The following offers a detailed explanation of the different types of assets and liabilities –
Mostly assets are classified based on 3 broad categories, namely –
|Convertibility||Depending on their extent of convertibility, they are further divided into fixed assets or current assets.|
|Physical existence||Comprise assets that are both tangible and intangible.|
|Purpose||Depending on their purpose of use, they are categorised as operating and non-operating assets.|
The following offers a fair idea about the different types of assets in general –
Current assets or short-term assets
These types of assets can be readily converted into cash or its equivalent resources typically within a year and are known as liquid assets. For example, cash equivalents, stock, marketable securities and short-term deposits are some of the most common current assets.
Fixed assets or long-term assets
Also known as hard assets and fixed assets, these resources are not easy to convert into cash or its equivalent kind. Generally, land, machinery, equipment, building, patents, trademarks, etc. are considered as fixed assets.
Similarly, assets with a physical existence are categorised as tangible assets. Resources like stock, land, building, office supplies, equipment, machinery and marketable securities, among others are functioning examples of tangible assets.
On the contrary, assets which do not possess a physical existence come under the category of intangible assets. The best examples of such assets would be market goodwill, corporate intellectual property, patents, copyrights, permits, trade secrets, brand, etc.
Assets like cash, building, machinery, equipment, copyright, goodwill, stock, etc. are termed as operating assets. Typically, such assets are used to generate revenue and to maintain daily operation.
Though these assets are not used for performing daily operations, they tend to help generate significant revenue. Some of the best examples of non-operating assets are short-term investments, vacant land, income generated through fixed deposits, etc.
In a commercial setup, liabilities can be divided into 2 broad categories of internal and external liability.
|Internal liability||Comprises obligations like capital, accumulated profits and salaries, among others.|
|External liability||Includes payables like taxes, overdrafts, creditors and borrowings.|
Further, liabilities are divided into 4 separate categories as per their function, namely –
Mostly, the account payables under this category are short-term in nature, which are to be meted out within a year. Payables like bills, trade creditors, bank overdrafts and outstanding bills among others are examples of current liabilities.
Also, known as fixed liabilities, these payables comprise long-term obligations that are generally not accounted for in a year. Usually, these types of liabilities are used for expansion purposes or for purchasing fixed assets. Debentures, long-term loans, bonds payable, etc. are among the common examples of non-current liabilities.
These are usually the types of obligations which may or may not occur for a commercial entity in the course of its operation. Guarantee for loans, claim against product warranty and lawsuits are examples of contingent liability. Business ventures are required to provide an estimate of contingent liabilities as a footnote on their respective balance sheet.
The table below enumerates the different types of assets and liabilities in a nutshell –
|Current assets and Fixed Assets||Current Liabilities|
|Tangible and Intangible Assets||Non-current Liabilities|
|Operating and Non-Operating Assets||Contingent Liabilities|
Relationship between Assets and Liabilities – A Glance through Financial Ratios
Since both assets and liabilities are a vital component for ensuring the profitability and sustainability of a commercial venture, individuals must figure out how to manage them effectively. However, to accomplish the same, one must identify the relationship between assets and liabilities in general.
Typically, a fine-tuning between the proportion of total assets and liabilities is a necessity for maintaining a company’s profitability. Further, it helps analyse the company’s ability to manage its external and internal liabilities as well as how readily it can convert assets into cash equivalent.
Assets and liabilities also help figure out the liquidity ratio of a particular business venture. It directly helps to analyse a company’s effectiveness to convert assets into cash or cash equivalent readily.
One can conveniently identify it by taking into account specific financial ratios which also tend to highlight the relationship between the two components.
For example, with the help of current ratio, one can successfully figure out a company’s ability to pay off existing debt. Here’s how one can calculate the same –
Current ratio = Current assets/ current liabilities
A company with a higher proportion of assets to liabilities tends to signify improved liquidity. In turn, it indicates that the business venture in question is in profits and thriving under the prevailing situation.
Similarly, the acid-test ratio is used to gauge a company’s ability to repay short-term liabilities with the help of quick assets. The ratio can be expressed as –
Acid-test ratio = Current assets – Inventories / Current liabilities
Alternatively, the cash ratio helps decipher a company’s ability to pay off short-term liabilities with the help of cash and cash equivalents. Cash ratio is expressed as –
Cash ratio = Cash and Cash equivalent / Current liabilities
Also, with the help of assets and liabilities, one can measure a company’s standing debt. To elaborate, the debt ratio is often a potent way of calculating the total’s assets of a company which was funded by debt. The formula of the same is expressed as –
Debt Ratio = Total Liabilities / Total Assets
On the other hand, both assets and liabilities play a pivotal role when it comes to computing the value of existing capital or owner’s equity. The said value is arrived at by calculating the difference between total assets and total liabilities at a given point of time. The same can be expressed as –
Owner’s equity = Total assets – Total liabilities
Hence, it can be said that a company’s assets and liabilities are vital when it comes to gauging its liquidity, debt repayment capability and profitability. This, in turn, makes it vital for intending investors to gather substantial information about the list of assets and liabilities held by a said company before investing in it.