Did you know that 43% of small businesses fail to track inventory and assets, and 82% of business failures are due to cash flow problems?
Whether you’re a private individual looking to achieve better wealth management, or an entrepreneur who needs to operate a financially sustainable business model—knowing the difference between assets vs liabilities is crucial.
Assets and liabilities might sound like intimidating terms on a balance sheet, but they are simpler to understand than a lot of people assume. They can also have a unique, interlinked relationship with each other. If you understand this relationship and its impact, you can achieve optimized wealth management, both personally and in the world of business.
Ready to get clear on the differences between assets vs liabilities? Continue reading to find out the fundamentals.
What Are Assets?
To get an idea of what are assets vs liabilities, let’s start by defining assets.
Assets are things you or your business owns, which you purchased in a transaction. In business accounting, assets are reflected in the balance sheet. This financial statement lists the totals of all your assets and liabilities and reflects shareholder equity.
Where a lot of people get confused is between assets and expenses. While asset expenditure goes on the balance sheet, expenses are reflected on the income statement.
But how do you decide what’s an expense and what’s an asset? Assets are usually larger, more costly items such as equipment, furniture, vehicles, and property.
Expenses are usually smaller, less costly items that a business has to repurchase frequently. For instance, if you have a coffee shop, the expresso machines would be an asset. The coffee beans would be an expense.
Alternatively, if you’ve been investing in real estate to rent out, the property is an asset. Any property management fees you pay would be an expense.
Assets on a balance sheet typically fall into the following four categories.
Short-term assets are any assets that will foreseeably be sold within a year, as well as liquid assets like cash in hand.
Here are some common types of short-term assets:
- Prepaid expenses (such as bulk orders of supplies or leased office equipment)
- Accounts receivable
- Cash on hand
As you can see, these types of assets should, in most cases, convert to cash within 12 months.
Long-term assets are assets that you intend to hold for more than a year. For a typical business, these could include things like:
- Land and buildings
- Equipment and machinery
- Long-term loans made
Take note that there are situations where you might want to sell a long-term asset within the span of one year. However, the intention behind long-term assets is to hold them over a long period of time.
Long-term assets that lose value over time are subject to depreciation. Through depreciation, you can lower their value on the balance sheet each year. This shows a truer reflection of their worth and means you won’t have to expense assets that have come to the end of their lifespan all in one go.
Intangible assets are made up of things you can’t “see” or which aren’t physical in nature. For instance, companies with good branding can often be worth far more than the sum of their tangible assets.
For instance, if you add up all of the tangible assets Coca-Cola owns, this will fall far short of the brand value. Brand value is a type of intangible asset.
Another example of an intangible asset is patents.
Do you remember what we said about depreciation on long-term assets? Depreciation is recorded on the balance sheet as a contra asset. Another common contra asset is allowance for doubtful accounts.
In a lot of businesses, there are occasional customers who run up a debt and don’t ever pay their account. If it looks like this is happening, the accountant or business owner will usually create an entry that decreases accounts receivable and increases the contra asset allowance for doubtful accounts.
In short, contra assets, although they are asset accounts, work to decrease regular asset accounts.
What Are Liabilities?
The other side to understanding the difference between assets vs liabilities is, of course, liabilities.
Liabilities are amounts that a company or individual owes. Liabilities constitute claims on assets that a business or individual owns. For instance, as an individual, if you owe someone money and don’t repay them, your personal assets could be seized to repay the debt.
If a business cannot meet its liabilities, it will face liquidation and the liquidated assets will go towards paying the liabilities.
Liabilities fall into two main categories on the balance sheet. These are short- and long-term liabilities.
Short-term liabilities mainly consist of:
- Accrued expenses
- Accounts payable
Accounts payable is any money owed to supplies and vendors. Accrued expenses are expenses that don’t yet have a direct invoice. For instance, the IRS collects employee taxes quarterly, but a business might withhold employee taxes on a weekly or monthly basis.
Most long-term liabilities are amounts that need to be repaid more than one year in the future. These are usually things like bank loans and mortgages. The terms on these can vary widely, spanning from a couple of years to multiple decades.
The Relationship Between Assets vs Liabilities
Although assets and liabilities are basically the opposite of each other, they can share an interlinked relationship.
For instance, if you take out a mortgage to purchase a property, you will acquire the property as an asset. However, you will also take on the liability of the mortgage. This results in a direct relationship between your assets vs liabilities.
Inventory vs payables is another commonly intertwined set of assets and liabilities.
At first glance, it can be easy to assume that assets are good and liabilities are bad. It is true that a healthy ratio of assets vs liabilities results in better equity. This is because equity = assets – liabilities.
However, not all debt is bad, and having an asset-heavy balance sheet isn’t the ultimate goal for most companies. In fact, investors are increasingly starting to prefer companies with fewer physical assets as this can be a sign of agility and smarter use of capital.
Now You Know the Difference Between Assets vs Liabilities
Whether you want to get better at personal wealth management, or business finances, understanding the differences and relationship between assets vs liabilities is a good start.
Do you need help with wealth management, personal finance, or tax planning? If yes, we are here to help.
Bogart Wealth is committed to helping people like you achieve peace of mind through maximizing and preserving intergenerational wealth. Contact Bogart Wealth today to discuss your wealth management needs.