Assets, liabilities and equity

In simple terms

A company's financial position at a moment in time comes down to three things.

• Assets are what the business owns or controls that has value: cash, money owed by customers, stock, machinery, buildings, and things like patents.
• Liabilities are what it owes to others: loans, money owed to suppliers, salaries due, taxes due.
• Equity (or shareholders' equity) is what is left for the owners: the assets minus the liabilities.

These three are tied together by the most important equation in accounting.

The equation always balances, because every asset a business has was paid for in one of two ways: with money it owes to someone (a liability), or with money that belongs to its owners (equity).

Current and non-current

Balance sheets split assets and liabilities by timing.

Comparing current assets with current liabilities gives a quick sense of whether a business can pay its bills over the next year.

Where equity comes from

Equity has two main sources.

• Share capital: money the owners put into the business when it issued shares.
• Retained earnings: profits the business has made over the years and kept, rather than paying out as dividends.

So equity rises when a company issues new shares or keeps profits, and falls when it makes losses or pays dividends.

Reading a simple balance sheet

How transactions keep it balanced

Every transaction changes at least two items, in a way that keeps the equation true.

• The bakery borrows ₹2 lakh. Cash (an asset) rises by ₹2 lakh, and the loan (a liability) rises by ₹2 lakh.
• It uses ₹1 lakh of cash to buy a mixer. Cash falls by ₹1 lakh and equipment rises by ₹1 lakh. Total assets are unchanged.
• It makes ₹50,000 of profit, received in cash. Cash rises by ₹50,000 and retained earnings, part of equity, rise by ₹50,000.
• It pays a ₹30,000 dividend. Cash falls by ₹30,000 and retained earnings fall by ₹30,000.

This is why a balance sheet always balances. If it does not, there is a mistake.

Book value and market value

The equity on the balance sheet is called book value. It is based on accounting records: mostly what assets cost, minus depreciation, plus profits kept.

The stock market often values a company very differently. A software company might have little equipment and a modest book value, yet a market capitalisation many times larger, because investors value its future profits, its brand and its people, none of which appear fully on the balance sheet. A struggling company can trade below its book value if investors doubt its assets are worth what the books say.

Why it matters

The balance sheet shows how a company is financed and how much cushion it has. A business with large debts and little equity can be wiped out by a bad year, because lenders must be paid whatever happens. A business funded mostly by equity has more room to absorb losses. Later paths turn these ideas into ratios such as debt-to-equity and return on equity.

The accounting equation also helps you spot nonsense. If someone claims a company has huge assets, the next question is: who financed them, lenders or owners?

Limitations

A balance sheet is a snapshot of one day, usually the last day of the financial year. The position the day before or after can be quite different. Many valuable things, such as a strong brand, loyal customers or skilled staff, are mostly missing, while some recorded assets, such as old equipment or doubtful receivables, may be worth less than the books say. Book value is a starting point for judgement, not a final answer.

Common mistakes

• Treating equity as cash. Equity is a claim on the assets, which may be machinery, stock or receivables rather than cash.
• Thinking a large balance sheet means a strong company. Large assets funded by large debts can be fragile.
• Treating book value as what the company is worth. The market's valuation can be far above or below it.
• Forgetting that losses reduce equity. Years of losses can shrink equity to zero or below.

Try it yourself

A made-up company, Sutlej Motors Ltd, has: cash ₹40 crore, receivables ₹60 crore, stock ₹80 crore, factories and machinery ₹320 crore, money owed to suppliers ₹70 crore, short-term loans ₹30 crore, long-term loans ₹200 crore and share capital ₹50 crore.

1. What are total assets and total liabilities?
2. What must its retained earnings be for the balance sheet to balance?
3. What are its current assets and current liabilities?

Answers: assets ₹500 crore; liabilities ₹300 crore; equity must be ₹200 crore, so retained earnings are ₹200 − ₹50 = ₹150 crore; current assets ₹180 crore and current liabilities ₹100 crore.