When you’re looking at your business financials, three contributing factors serve as the foundation of your accounting: assets, liabilities, and equity. Find out what each term means, plus what role it plays on a business balance sheet, so you can better understand how your company is financially performing at any given time.
Key Points
• Assets, liabilities, and equity are the factors in the accounting equation, which is fundamental to double-entry bookkeeping. Assets vs. equity plus liabilities should balance.
• Assets represent anything of value that helps a company earn income and can include tangible items like property, intangible elements like brand reputation, and intellectual property such as patents.
• Liabilities are debts that detract from a company’s value, but these debts may be necessary for a business if it wishes to purchase a higher-ticket item without paying the full amount upfront.
• Equity measures true business value by subtracting total liabilities from total assets, with higher assets and lower liabilities resulting in greater equity for the company overall.
• Balance sheets display assets equaling the sum of liabilities plus equity, with equity type varying by business structure — owner’s equity for sole proprietors or shareholders’ equity for corporations.
The Accounting Equation (Assets = Liabilities + Equity)
The accounting equation is a core part of double-entry bookkeeping, the standard for most businesses. This system can help your business keep clean, balanced accounts so that you have an accurate picture of your firm’s financial health.
In double-entry bookkeeping, you track your assets, liabilities, and equity separately on the balance sheet. To be in balance, both sides of the equation should add up to the same amount. For instance, say a fitness studio financed five new treadmills for $3,000 each, totaling $15,000. The business’s assets tally would increase by $15,000, as would its liabilities.
As the formula indicates, a company’s assets should equal its liabilities plus its equity. Equity might include owner contributions, net profits, or shareholder investments. You can see how all three factors in the accounting equation work together on a small business balance sheet.
What Are Assets?
Business assets are anything of value used to help your company earn income. They also add value to your business. If you were ever to sell your company, its assets would be included in the valuation.
When you’re applying for financing like a business line of credit or startup business loan, the lender will probably review your assets to help decide how much your company can borrow. Equipment financing is also often based on the value of an asset, since the equipment itself is used to secure the loan.
Types of Assets
There are several ways you can categorize assets. The U.S. Small Business Administration (SBA) uses three categories:
• Tangible: These assets typically include property or equipment used in the business. They tend to lose value as they age. They’re listed on your balance sheet.
• Intangible: These assets can include your network, brand, and other nonphysical things. They add value to your business, but there’s no dollar amount assigned to them — so they do not appear on the balance sheet.
• Intellectual property: This is a type of intangible asset and includes things like trademarks, patents,and software that’s owned by your company and legally protected.
Another way to classify assets is by how quickly you can liquidate them into cash and get the funds delivered to your business checking account. Current assets can be sold quickly, while non-current assets are harder to liquidate.
Asset Examples
When calculating your business’s tangible assets, you can generally include inventory, real estate, vehicles, software, machinery, and IT equipment.
Your list of intangible assets might include branding, licenses, customer contracts, trademarks, domain names, and customer lists.
What Are Liabilities?
Assets and liabilities are two very different things. While assets add value to your company, business liabilities are the debts that detract from that value. The benefit of taking on liabilities is that it lets you pay for higher-ticket items and services without having to pay the full amount at one time. Whether you don’t have the capital or you want to preserve your cash, borrowing funds can potentially fuel your business growth.
Types of Liabilities
Just as with assets, business liabilities can be broken down in a few different ways:
• Secured or unsecured: This distinguishes between debts that are tied to collateral (secured) versus those that don’t have any collateral attached to them.
• Current or long-term: Short-term liabilities (due within a year) are considered current, while loans with longer terms are considered long-term.
• Contingent liabilities: Rather than referring to a debt that already exists, contingent liabilities depend on potential future outcomes. For instance, a lawsuit settlement that’s likely to happen and has a firm monetary estimate could be listed as a contingent liability.
Liability Examples
Equipment financing and real estate loans are common forms of secured liabilities. Balances on small business credit cards, on the other hand, are usually unsecured liabilities.
Current liabilities could include taxes, short-term debt, accounts payable, operating lease liabilities, and accrued salaries. Long-term liabilities could include some small business loans, pension liabilities, deferred compensation, and deferred income taxes.
What Is Equity?
Equity represents ownership stake in the company. You may be wondering what the difference is between equity vs. assets: Consider the formula. If you add up your business’s total assets and subtract its total liabilities, the remaining value is its equity.
Owner’s Equity vs. Shareholders’ Equity
The type of equity in your company depends on its type of business formation. Owner’s equity is used for sole proprietors and single-owner LLCs, while shareholders’ equity is used to describe stock shares of a corporation.
How Equity Changes Over Time
Your company’s equity will continually evolve over time as your assets and liabilities change. When you first start your business, you may be spending and financing more than you receive in revenue. But as you scale, your assets may come to outweigh your liabilities, increasing the amount of equity available.
How Assets, Liabilities, and Equity Appear on a Balance Sheet
All three components play different roles in your company’s financial health. And whether you’re focused on assets, liabilities, or equity, you should be able to find them all on your balance sheet. Typically, assets are listed together at the top of the balance sheet. Then liabilities and equity are listed in a separate section below.
Simple Balance Sheet Example
If you’re wondering how an asset, liability, or equity entry would appear on a basic balance sheet, this simplified example of an imaginary company’s balance sheet may help.
| ASSETS | LIABILITIES | ||
|---|---|---|---|
| Current Assets | Current Liabilities | ||
| Cash | $10,000 | Wages Payable | $6,000 |
| Accounts Receivable | $20,000 | Accounts Payable | $4,500 |
| Inventory | $35,000 | Taxes Payable | $9,000 |
| Total Current Assets | $65,000 | Short-Term Loans Payable | $4,000 |
| Total Current Liabilities | $23,500 | ||
| Non-Current Assets | Non-Current Liabilities | ||
| Office Equipment | $6,500 | Long-Term Liabilities | $25,000 |
| Real Estate | $22,000 | Long-Term Debt | $25,000 |
| Total Non-Current Assets | $28,500 | Total Non-Current Liabilities | $50,000 |
| EQUITY | |||
| Owner’s Equity | $20,000 | ||
| Total Equity | $20,000 |
Note that this example sheet balances: Total assets ($93,500) equal total liabilities ($73,500) plus total equity ($20,000).
Common Mistakes to Avoid When Classifying Accounts
It’s important to classify your account entries correctly. Otherwise, your financial statements could have inaccurate profit margins or over-reported income. Watch out for these mistakes that many small businesses can fall into:
• Waiting too long: Putting off account reconciliation makes it harder to track down accurate numbers or figure out where mistakes came from. Have your bookkeeper schedule time regularly, and make sure you also review for accuracy.
• Misclassifying expenses: Certain long-term assets, called capital assets, are usually depreciated over several years. They need to be classified appropriately so the business doesn’t incorrectly deduct the full amount in one year.
• Human error in data entry: Adding an extra number or placing a decimal point in the wrong place can cause major discrepancies. Using the double-entry bookkeeping system helps prevent these problems from snowballing because both assets and liabilities should be the same. If they’re not, you know something is amiss.
The Takeaway
Understanding the differences among assets, liabilities, and equity is a fundamental part of business accounting. Plus, being informed and able to keep a balance sheet with these components can give you a better, more accurate sense of your company’s financial health.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What are assets, liabilities, and equity in simple terms?
In simple terms, assets are tangible and intangible valuables owned by a company. Liabilities refer to debt, while equity is the amount left for owners or shareholders. When you’re looking for assets, liabilities, or equity totals, they should appear on your business’s balance sheet.
What is the accounting equation?
The accounting equation is Assets = Liabilities + Equity. In other words, a business’s combined liabilities and equity should be equal to its assets.
Is equity the same as profit?
Profit is different from equity. Profit refers to earnings after expenses over a specific period of time. Equity, on the other hand, is the ownership value of the business.
What are examples of assets and liabilities?
Assets can be items of value like inventory, equipment, real estate, or intellectual property. Liabilities, on the other hand, refer to debts and other ongoing, expected costs incurred by the business.
How do assets and liabilities affect equity?
Equity is calculated by subtracting a business’s liabilities from its assets. Higher assets and lower liabilities mean more equity.
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