Assets & Liabilities – Meaning, Types & Differences

For any business to succeed, it has to manage its assets and liabilities efficiently. But what are assets and liabilities exactly? If you’re not well-versed in the financial aspects of a business, you may not know what these two terms represent. In this article, we’re going to delve into the concept of assets and liabilities, their different types and the various points of difference between the two. 

Assets and Liabilities Meaning

Assets and liabilities are two of the most important components in finance and accounting. All of the resources, whether they’re tangible or intangible, with any kind of economic value that a company or individual owns are termed assets. Assets are often used to generate revenue and other economic benefits. 

Liabilities, meanwhile, is a term used to refer to debts and other obligations that a company or individual owes to third parties. Liabilities need to be repaid or settled by the company through the transfer of cash or other non-cash benefits. 

What Is an Asset?

A company’s assets play a crucial role in cost reduction and revenue enhancement. An increase in assets directly correlates with heightened profits and the generation of positive cash flow. The economic value of a business’s assets signifies their potential exchange or sale in the market. The calculation of an organisation’s assets follows a defined formula, wherein total assets equal the sum of liabilities (accounts payable) and owner’s equity. This equation provides a comprehensive view of a company’s financial standing, illustrating the relationship between its liabilities, owner’s investment, and the valuable assets contributing to its overall economic strength.

Examples of Assets:

• Cash holdings, including currency and equivalents
• Diverse investments in financial instruments
• Varied inventory of goods and materials
• Office equipment encompassing technology and furnishings
• Specialised machinery for production or operations
• Real estate properties owned by the company
• The fleet of company-owned vehicles for transportation and logistics

What Is a Liability?

A company’s liability encompasses all its outstanding payables to various accounts and parties. Minimising liabilities is advantageous for the company, contributing to its overall financial health. Liabilities are integral to a company’s financial growth and the seamless operation of daily commercial activities. The calculation of an organisation’s liabilities involves subtracting owner’s equity from assets (account receivable), as per the formula: Total liabilities = Assets (account receivable) – Owner’s equity. This formula provides a quantitative representation of the financial obligations a company holds, offering insights into its financial structure and the relationship between assets and owner’s equity.

Examples of Liabilities:

• Bank loans and other forms of debt
• Mortgage obligations on owned properties
• Outstanding payments to suppliers (accounts payable)
• Unsettled wages and salaries owed to employees
• Pending tax payments and obligations to tax authorities

What are the Different Types of Assets and Liabilities?

Now that you’re aware of what assets and liabilities are, let’s delve deeper into their various types. 

Types of Assets 

Assets can be broadly categorised into four major types – fixed assets, current assets, investments and other assets. Here’s a brief overview of each of these categories.

1. Fixed Assets 

Fixed assets are long-term assets intended for prolonged use; they’re often used to generate revenue and income. Fixed assets can either be tangible (physical assets) or intangible (non-physical assets). Examples of tangible fixed assets include land, buildings, machinery and vehicles, whereas intangible fixed assets include patents, trademarks and goodwill. 

2. Current Assets 

Current assets are short-term assets that are either used or converted into cash within the span of a year. Unlike fixed assets, current assets are more liquid and are vital for the day-to-day operations of a business. Some examples of current assets are cash, short-term investments with maturities of less than one year, accounts receivables and inventory.  

3. Investments

Investments refer to long-term investments with maturities of more than a year. Equity stocks, bonds, debentures and promissory notes are some examples of long-term investments.

4. Other Assets 

Assets that cannot be classified into any of the above-mentioned categories are referred to as other assets. Prepaid expenses, which are payments made for goods and services in advance, are categorised as other assets. 

Types of Liabilities 

Similar to assets, liabilities can also be broadly categorised into four major types – shareholders’ equity, long-term liabilities, short-term liabilities and other liabilities. Here’s a brief overview of each of these categories.

1. Shareholders’ Equity

The shareholders’ equity represents the total amount invested by shareholders in the company. This category also features retained earnings, which are business profits that have not yet been used or distributed as dividends. 

2. Long-Term Liabilities

Long-term liabilities refer to debt obligations with maturities of more than a year. They include unsecured and secured loans, mortgages and deferred tax liabilities, which are taxes that may become payable in the future. 

3. Current Liabilities

Current liabilities are short-term debt obligations with maturities of less than a year. They include short-term loans, expenses incurred but not yet paid (accrued liabilities) and accounts payable, which are essentially amounts owed to suppliers and vendors. 

4. Other Liabilities

Other liabilities are miscellaneous obligations that cannot be classified into any of the above three categories. Deferred revenue, which is payments for goods and services received in advance, is an example of other liabilities.   

Establishing a Relationship Between Assets and Liabilities Through Financial Ratios

With the types of assets and liabilities out of the way, let’s now look at financial ratios and how they establish a relationship between two seemingly opposite financial concepts. 

Financial ratios are metrics that indicate the financial performance and health of a company. These ratios often take both the assets and liabilities into account. Here are a few of the most crucial financial ratios that experts use to ascertain the financial health of a company. 

• Owner’s Equity 

Owner’s equity is a metric that indicates the total value of the shares held by the owners of the company. It is computed using the following formula. 

• Cash Ratio

The cash ratio is a financial metric that indicates how capable a company is of meeting its short-term debt obligations using its cash reserves. The higher the cash ratio, the better since it suggests that the company has enough cash to cover all of its short-term liabilities. The ratio can be computed using the following formula. 

• Current Ratio 

The current ratio is a metric that measures how capable a company is of meeting all of its short-term liabilities with its current assets. The higher the current ratio, the better the financial health of the company is. To calculate the current ratio, all you need to do is use the below-mentioned formula. 

• Acid Test Ratio 

The acid test ratio is a metric that’s used to determine a company’s ability to pay off its current liabilities using its current assets minus existing inventory. The higher the ratio, the better the company’s ability to meet its liabilities. The formula you need to use to compute the acid test ratio is as follows. 

• Debt Ratio 

The debt ratio is a metric that indicates the amount of debt a company has taken on relative to its total assets. The lower the ratio is, the better since it would mean that the company has more assets than debt. Here’s the formula for the debt ratio. 

What are the Differences Between Assets and Liabilities?

As you’ve already seen, there’s a stark contrast between assets and liabilities. Here’s a table outlining the key points of difference between the two.

Conclusion

With this, you must know what assets and liabilities are. The goal for every company is often to have a healthy balance between assets and liabilities to ensure financial stability and solvency. 

FAQs