Businesses juggle so much information in their day-to-day operations that they can start to lose sight of the big picture. While profit is ultimately the goal, a sustainable business needs to do more than simply generate cash.
How that cash is held and where it goes once it’s acquired are equally important parts of the picture.
Almost all transactions will either flow to or from assets and liabilities. Understanding both categories isn’t just necessary for accurate recordkeeping, but for getting a grasp on a business’s financial health and long-term viability.
Here’s what you need to know about assets and liabilities, and how they fit into the bigger picture of knowing your business.
What is an asset?
An asset is anything that a business owns that will generate future economic benefit and are used in a business’s operations. The most common asset business has is cash and cash equivalents held in bank accounts, digital wallets, and on hand. Assets also include items that provide future value or represent future earnings such as inventory, accounts receivable, and capital assets (which have a useful life beyond the fiscal year).
What is a liability?
A liability is what the business owes to vendors, creditors, lenders, investors, employees, or government agencies.
Compared to assets, liabilities are much easier to classify. In almost any instance of money being owed, it will be categorized as a liability.
Common examples of liabilities include credit cards, loans, lines of credit, accounts payable, and payroll taxes.
Assets vs liabilities
The key distinction between assets and liabilities is what is owned versus what is owed.
Assets include anything that brings value to the business that they own. It could represent future cash flows (like accounts receivable), capitalized items that have long term value (like PP&E), or the cash held by the business.
Liabilities are what’s owed to a lender, creditor, owner, or other business. They represent cash that’s promised to another entity with payments that need to be planned for.
A business’s financial health is heavily tied to keeping what’s owed (liabilities) in check based on what’s owned (assets).
Assets vs. liabilities vs. equity
The last piece of the balance sheet puzzle is equity. Equity can be thought of as what’s left over in the business after all assets and liabilities are accounted for and distributed to ownership.
Equity is calculated using the accounting equation which is:
How equity is treated on the balance sheet depends on the business type. In some cases, equity is distributed directly to the ownership group, and in others it must be held in the company for reinvestment with dividends paid out to shareholders.
Where do assets and liabilities appear on the balance sheet?
On a traditional balance sheet, there are three components: assets, liabilities, and equity.
The balance sheet is structured from top to bottom to mimic the accounting equation (covered above).
So when you read a balance sheet from top to bottom, the categories appear in the order of:
- Assets: what the business owns
- Liabilities: what the business owes
- Equity: what would be left over if all assets were liquidated and liabilities paid
In some cases, businesses will separate both assets and liabilities into current and noncurrent classifications. If they choose to do this, it’s most common to have current assets come before noncurrent assets and current liabilities come before noncurrent liabilities.
Importance of tracking assets and liabilities
Assets and liabilities are not things you should check up on once in a while. Track both and follow our tips to get the most value from these essential financial metrics.
Liabilities to asset ratios (L/A ratios)
Financial ratios are ways business owners, executives, lenders, and investors understand the health of a business at a glance. Below are four ratios frequently used in evaluating businesses that use both assets and liabilities.
The debt-to-asset ratio
The quickest and easiest ratio you can calculate using assets and liabilities is the debt-to-asset ratio.
The debt-to-asset ratio equation is:
The ratio is a measurement of how much debt has been used to finance the building of a business’s assets. For example, if a business has a debt-to-asset ratio of 0.3, it’s said to have 30% of the assets funded by debt.
Used primarily as investors for benchmarking purposes, it’s still worthwhile for business owners to track this ratio over time.
If the debt-to-asset ratio is going down, the business is seen as less dependent on debt. But if it’s increasing, the business is considered to be more dependent on debt and may not be generating enough capital from its operations to be sustainable.
The current ratio
The current ratio (also called the working capital ratio) measures a company’s ability to pay down it’s short-term debts using only its short-term assets. The equation is:
If the current ratio is 1 or greater, then the business has enough short-term value to cover its short-term debts in the immediate future. If it dips below 1, then the business is at risk of defaulting on its debts.
The quick ratio
The quick ratio is similar to the current ratio, but does not include inventory in the equation. It operates on the assumption that the inventory cannot be liquidated to pay down debts and thus is a more conservative estimate.
The quick ratio equation is:
Just like the current ratio, a measurement of 1 or greater means the business can sustainably pay down its debts in the immediate future. But if it’s below 1, the business may not be able to cover what it owes.
The role of assets and liabilities in decision-making
Together, assets and liabilities hold crucial information that guides a business’s decision-making. In particular, financial experts refer to both sections on the balance sheet to understand:
- What is the business’s financial health? A healthy business has value on hand to pay down its debts with room left over for flexibility. Look at current assets and current liabilities to get a clear picture of a business’s financial health in the short-term future.
- What money is available to invest in the business? The difference between assets and liabilities represents capital that can be reinvested in the business. Alternatively, it represents the room to take on additional debt without putting the business at significant risk.
- Is there currently risk that needs to be managed? A business is at risk if it doesn’t have enough short-term assets or incoming cash flow to manage debt payments on top of its expenses. A well-crafted budget or cash flow forecast helps with this.
- What’s the long-term sustainability of the business? Beyond the short-term, a business should understand its long-term sustainability through assets and liabilities. Scalable assets (like real estate and intellectual property) represent opportunities for growth while liabilities show whether the business can take on more debt to fund that growth or if it needs to do so through other means.
When planning for the future of a business, always look at the assets and liabilities. There may be more opportunity than you initially considered, or you may need to scale back ambitions to grow sustainably and minimize risk.
Improving asset and liability management with BILL
Two big components of a business’s assets and liabilities respectively are accounts receivable and accounts payable. Not only are they drivers of cash flow, but they take time to manage, analyze, and understand.
That’s why BILL’s platform makes it simple to get paid, make payments, and track what’s coming in and going out with ease.
Streamline your invoicing and accounts receivable process with templates and easily imported information. One-click payments get you cash in hand quicker.
Get all the info you need on accounts payable and pending payments with automated workflows that push accounts payable approvals through faster and make payments a breeze.
