At some point in your life, you have owned something (We hope you still do now!). Take for example your hard-earned money. In exchange for doing your job, you get paid with “cash”. The money that you earn becomes yours. This money is considered your asset because you own it. But.. SURPRISE! Not everything you own will be yours in the end. Yes, we feel you, buddy. Sad but true. Why, though?
We’re sure most of you have those shiny plastic god-sent little friends we fondly call credit cards. Credit cards allow us to pay for the stuff that we buy without having to shell out cash. Of course, the life lesson we had to learn the hard way teaches us that nothing in this world is free. You have to pay it back to the credit company at some point. Once you’ve already swiped your credit card, the amount automatically becomes something you owe. This is now your liability because it is an obligation that you have to repay.
Since repayment of your credit will entail shelling out cash, we can say that the person or company that granted you credit (i.e., your creditors) has claim to your cash, which is your asset. So, let’s say you have $1,000 worth of cash and $400 worth of credit card purchases. Your one grand is not entirely yours as half of this represents the claim of your creditors (which in this case is Visa or Mastercard). At the end of the day, only the remaining $600 is truly yours. This is your equity.
The same thing goes for businesses. They, too, have assets, liabilities and equity. So, how do we define and differentiate the three?
Note: Some of the elements used in the illustration were obtained from Freepik.com.
Before we go to the technicalities, it is important to keep in mind the basic accounting equation that is fundamental to understanding the relationship between these three things:
Assets = Liabilities + Equity
What Are Assets?
Assets are tangible and intangible items that the company owns that are expected to provide future economic benefits to the business. Tangible items include cash, inventories, supplies, building, equipment, etc. On the other hand, intangible items include accounts receivable, investments, patents, copyright, goodwill, etc.
What Are Liabilities?
Liabilities are the financial obligations of the business to pay its creditors. These arise during business operations. Examples of liabilities include accounts payable (those payable to the company’s vendors), loans, unpaid salaries and wages, mortgages and so on. The key thing to remember about liabilities is that when you pay them back, it will result in a decrease in economic benefit (decrease in assets) or you will incur another liability. For instance, a $1,000 debt may either be paid by cash (decrease in assets) or paid by borrowing money again (incurring another liability).
It is also important to know that, between the creditors and owners, the creditors have the first claim to the company’s assets, and only then do the owners. So in the unfortunate instance that a business closes and undergoes liquidation, creditors have the first dibs on the company’s assets and they all have to be repaid first before the remaining assets get distributed to the owners or shareholders.
What Is Equity?
The keyword you need to take note of when referring to equity is “residual”. After paying off your creditors, the remaining assets of the business are the equity of the owners. Simply put, equity is the financial share of the owners in a company. It is also known as “net worth”. The basic formula for computing equity is:
Equity = Money Invested – Money Withdrawn + (-) Accumulation of Earnings
For example, you are a business owner. You have invested $1,000. During the year, you have decided to withdraw $100. At the end of the year, you got a total profit of $200. Your equity, then, will be $1,000 (initial investment) minus $100 (withdrawals) plus $200 (profit) – a total of $1,100! Yay!
The Bottom Line
Understanding the basic accounting equation and its elements is key to understanding the company in which you’d like to invest into or are currently investing.