In its simplest form, your balance sheet can be divided into two categories: assets and liabilities. Assets are the items your company owns that can provide future economic benefit. Liabilities are what you owe other parties. In short, assets put money in your pocket, and liabilities take money out!
Assets vs. Liabilities
Assets add value to your company and increase your company’s equity, while liabilities decrease your company’s value and equity. The more your assets outweigh your liabilities, the stronger the financial health of your business. But if you find yourself with more liabilities than assets, you may be on the cusp of going out of business.
Examples of assets are:
- Office equipment
- Real estate
- Company-owned vehicles
Examples of liabilities are:
- Bank debt
- Mortgage debt
- Money owed to suppliers (accounts payable)
- Wages owed
- Taxes owed
What is Liquidity?
Assets are often grouped based on their liquidity or how quickly the asset can be turned into cash. The most liquid asset on your balance sheet is cash since it can be used immediately to pay a liability. The opposite is an illiquid asset like a factory, because the selling process (converting the property to cash) will likely be lengthy.
The most liquid assets are called current assets. These assets can be converted to cash in less than a year and include cash, marketable securities, inventory, and accounts receivable. These assets generate revenue for your company.
Non-liquid assets are grouped together into the category of fixed assets. These include real estate, vehicles, and machinery. Fixed assets are owned by your company and contribute to the income but are not consumed in the income generating process and are not held for cash conversion purposes. Fixed assets are tangible items usually requiring significant cash outlay and lasting for an extended period of time.
Current vs. Long-Term Liabilities
Liabilities are also grouped into two categories: current liabilities and long-term liabilities. Current liabilities are those that are due in the next year, while long-term liabilities will not be due until at least a year later.
Current liabilities typically represent money owed for operating expenses, such as accounts payable, wages, and taxes. In addition, payments on long-term debt owed in the next year will be listed in current liabilities. For example, if you have a 30-year mortgage on your building, the next year’s worth of payments owed will be listed in the current liabilities section while the remaining balance will be shown as a long-term liability.
As a small business owner, one of your most important goals will be to balance your books. That means you need a solid understanding of assets and liabilities in order to make good decisions and evaluate the health of your business. Once the terms are defined, understanding assets and liabilities is fairly easy, and the financial reports you’ve been generating will start to have more meaning!