If you’re a business owner but don’t have a substantial finance or accounting background, terminologies like liabilities, asset, and equity might confuse you. However, while managing your books and accounts, it is essential to understand these concepts and all that they entail.

Before getting into the assets vs equity discussion, you must understand what liabilities are.

What is liability?

Liability is the amount of money you owe to third parties such as a bank, a loan shark, or even your employees in terms of salary that hasn’t been paid yet. The money may have been procured only once at the beginning, known as the startup capital, or it may have a monthly or annual renewal (loans and mortgages) but you are legally and financially obligated to pay it back, even if your business were to shut down. Having established that, in simple terms, equity is the difference between your assets and your liabilities. This is known as the accounting equation, and it is what links asset and equity.

What are assets?

Assets are valuable monetary goods or entities that you or a company owns. They are obtained as a result of past events or transactions. For example, a house you own is an asset but if that same house is purchased on a mortgage, it is a liability. Asset are signified by ownership and may be current or fixed.

Current asset are anything of value that can be converted into cash in a short period, mostly within a year. They are also known as liquid assets, responsible for daily cash flow.

They mainly comprise of:

• Inventory: Fiscal stock or goods that would be sold to obtain money.
• Accounts Receivable: Money owed by the customers once they purchase the inventory.
• Cash: Once the customers pay you, the accounts receivable turn into cash.
• Prepayments: Deferred tax assets and prepaid expenses such as rent as they provide you economic benefit for the rest of the month.
• Short-term investments: Stocks and shares held on for less than a year.

On the other hand, fixed assets are long-term assets that cannot be converted into cash in the short run but are used for daily operations to generate user benefit and profit.

These include:

• Long-term investments: Stocks, shares, or patents held on for longer than one year.
• Tangible assets: Property, Plant & Equipment (PPE) which includes land, vehicles, furniture, and machinery among other goods.
• Intangible Assets: Goodwill, the value of your brand, and intellectual properties such as patents, trademarks, and copyrights.

A significant difference in equity vs assets is that assets are tangible and may be offered as collateral whereas equity cannot. These tangible or ‘hard’ assets may depreciate over time. For example, you purchased a laptop today for $1000. As new products are released in the market, they will lose their value over time due to wear and tear, eventually having none after significant time passes.

Thereby, all hard assets have a useful economic life. Cash and cash equivalents, however, lose little to no value over time. Another key difference in assets vs equity is that equity doesn’t depreciate over time.

A successful business, in simple terms, has a high ratio of assets to liabilities. You own much more than you owe.

Equity

Equity = Assets – Liabilities

If equity is equal to assets minus liability, assets are what you own and liability is what you owe, and equity is simply how much you have ownership over. In layman terms, it is what you will take home after paying off all your debt if your business were to shut down.

In a small business, however, equity is usually equal to what the business is worth. Thus, the value of equity vs assets is the same. By extension, it is the net assets of the company left over, more commonly known in media as ‘net worth’.

If you borrowed $5000 from a friend and added $1000 on top of that to purchase a car worth $6000, you have an equity of only $1000 even though your asset is worth six times that. This is because $5000 of its value is a liability that you need to pay back.

Equity mainly comprises of:

• Capital contribution: Monetary funds invested into the business out of your own pockets; also known as owner’s equity in a proprietorship, partner’s equity in a partnership, and stockholder’s equity in a corporation, depending on the type of business.
• Retained earnings: Accumulated profits held for future use.
• Withdrawals: Money taken by the owner, which may be extended to personal use; also known as drawings, partner drawings, and dividends. When you withdraw money, your assets reduce as cash goes down and so does your equity because your claim on those net assets has been reduced.

Equity = Capital Contribution + Retained earnings – Withdrawals

When comparing equity vs assets, asset are the resources used to generate funds whereas equity is the funds used to procure those resources in the first place. An owner’s equity increases upon further contribution into the business, as well as upon further reinvestment of the earnings to expand it, whereas any distribution of funds to the owners reduces equity.

Therefore, changes in equity are largely linked to changes in assets, though that may not always be the case such as when the assets of a company may increase after taking a loan, which can be categorized as a liability. One can say that asset and equity are two sides of the same coin.

Moreover, the success of the business has a significant impact on the owner’s equity since liabilities are pre-determined. That is to say, a creditor obtains a fixed amount each month. In assets vs equity, asset belong to the company whereas equity is personal. If the business asset reduce, so does the owner’s equity.

See Also: What Is Depreciation? And How Do You Calculate It?

Calculation of assets vs equity

Let’s suppose you and three of your friends decide to start a business and each of you contributes $5000 to this venture.

Assets = 20000$

Liability = 0$

Equity = 20000$

To rent an office and supplies to set up a workspace, you take out a $5000 loan.

Assets = 25,000$

Liability = 5000$

Equity = 20,000$

After purchasing the equipment worth 17,000$, the final assets vs equity will be the same as written above, except that the assets will now be $17,000 in the form of equipment and $8000 in cash.

Note that even though your business is technically worth $25,000, your equity is only 20,000$ which was your initial capital contribution.

The bottom line

Apart from understanding assets vs. equity, it is also equally critical to understand the liabilities concept to be aware of how much your business is worth, how much you owe, and how much is left over. This will help you organize and streamline your balance sheet, which is pertinent for a successful business so that every fund is accounted for.

Farwah Jafri

Farwah is the Product Owner of Monily. She has an MBA from Alliance Manchester Business School, UK. She is passionate about helping businesses overcome challenges that hamper their growth, which is why she is working at Monily to facilitate entrepreneurs to efficiently manage business finances and stay focused on growth.