What are Assets and Liabilities? Once you understand how the terms assets and
liabilities are used in business, you can use that knowledge to your benefit in your
personal life as well. In accounting, assets and liabilities are
terms that you will find on the balance sheet. What you own is on the left: assets. What you owe is on the right: liabilities
and equity. Let’s work through some examples of assets
and liabilities. What about a machine that the company bought
to produce goods that it is selling? This is a tangible fixed asset, something
that the company owns and that has physical form. Let’s place that in assets on the left. What about Accounts Receivable? These are invoices sent to the customer, which
the customer has not paid yet. This is an asset as well: we own the right
to collect the money for the goods or services we have delivered. What about Accounts Payable? These are invoices received from a supplier,
which the company has not paid yet. This is a liability: we owe money to the supplier. Let’s place that on the right. Cash. Cash is a financial asset. Cash is very liquid, in most cases you can
use it immediately to pay your obligations. Inventory. Inventory is an asset as well. These are goods that we own, and intend to
sell. A loan agreement, a borrowing, debt. The company owes money to the bank. This is a liability. We now have many of the elements of a balance
sheet for a company. There is one more very important element,
which fits in the bottom right corner of the balance sheet: equity. Equity is the shareholder capital. You can calculate it by taking the total value of the assets minus the total value of the liabilities. Now that you understand the picture of assets,
liabilities and equity on the balance sheet, let’s think of the dynamics going on in
a company. A company will try to generate a return on
assets. If the revenues generated (from selling goods
and services) are bigger than the expenses (such as labor, materials, and depreciation
of manufacturing equipment), then the company generates a profit. Return On Assets relates the amount of profit made to the assets needed to generate that profit. Some companies need very few assets to generate
a substantial profit. Other companies may need a lot of assets to
generate only a modest profit. Increasing ROA is generally a good thing. On the liability side, having debt generates
a cost of borrowing. The amount of interest that a company pays
depends on the amount borrowed and the interest rate. If a company improves its financial health,
its cost of borrowing tends to go down. In general, it is good to have a Return On
Assets that far exceeds the cost of borrowing. Let’s apply what we learned about assets
and liabilities to assets and liabilities in your personal life. What if you own a house? That’s an asset. However, if you rent a house as a tenant,
then you wouldn’t put the house on your balance sheet as an asset, as you don’t
own it. What if you own a car? That is an asset as well. If you lease a car, you wouldn’t put the
car on your balance sheet as an asset, as you don’t own it. What about cash? That is an asset. Unpaid creditcard bills? A liability. A portfolio of stocks? An asset. A loan agreement with a bank (for example
the mortgage loan on your house)? A liability. There is one more element, which fits in the
bottom right corner of the balance sheet: equity. You can calculate it by taking the total value
of the assets minus the total value of the liabilities. Within the assets in your personal life, there
can be items that we call (potential) “earning assets”: cash in a savings account that
pays you interest, and stocks in an investment portfolio that pay a dividend or go up (or
down!) in value. Just like companies monitor their cost of
borrowing closely, you should also keep track of your cost of borrowing on various types
of debt you might have outstanding. Chances are that the unpaid creditcard bills
carry the highest interest rate, and therefore should get the highest priority in paying
down! So what is financial wealth in somebody’s
personal life? A lot of people mistake wealth for assets. We tend to think that the more assets somebody
has, the wealthier that person is. But what if that beautiful yacht as well as
that fancy sports car are all debt-financed? Assets increase (the person owns more), but
liabilities also increase (the person owes more). The more debt you add, the more fragile you get. The true measure of financial wealth, which
is often not visible to the outside world, is the amount of equity that somebody has! Assets minus liabilities. Looking at somebody’s assets without knowing
how they are financed, might be deceiving. It might actually be the person with the smaller
house and the older car, but with very few or even no liabilities, that is the more financially
wealthy! Want to learn more about business, investing
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