Assets vs. Liabilities vs. Equity

Before we discuss the differences between the three permanent accounts in accounting, we should be exposed to, if not aware of the basic accounting equation. The basic accounting equation is the standard by which all organizations must follow under the U.S. financial system and helps determine the financial health and (business) performance of an individual or organization. The basic accounting equation is Assets = Liabilities + Equity (Tracie Miller-Nobles, 2018, p. 57).

The four financial statements: Income (Profit-Loss) Statement, Statement of Retained Earnings, Statement of Financial Position (Balance Sheet), and Statement of Cash Flows all share in relevant information that are obtained from the asset, liabilities, and equity accounts. Together, the financial statements provide a clear picture of an individual’s or organization’s financial health and (business) performance.

The simplest idea and explanation are to increase assets at a rate (say, 3%) that is higher than both liabilities and equity (say, 1% and 2% respectively) including inflation. Easier said than done, of course. But, if increasing assets at a higher (and more frequent rate) can be done, an individual or organization will definitely increase their value...aka their wealth!

3% ↑ = 1%↓ + 2% ↕

Assets

Assets are economic resources that are expected to benefit the business in the future – something the business owns or has control of that has value (p. 57). They are the central core of a financial portfolio. Assets are cash, treasury bills, accounts receivable, art, equipment, financial assets, foreign currency, land, buildings, furniture, fixtures, appliances, cars, boats, natural resources, bonds, cryptocurrency, 401(k) and 457 retirement accounts, insurance, and more. Some assets decrease (depreciate) in value, while others increase (appreciate). But all of which are assets an individual or organization owns, sells, or liquidates to receive income or earn a return on it.

In concept, assets can be viewed as ‘return’. Increased returns can provide an individual or organization the capital they may need to make capital investments.

The ‘free game’ regarding assets is to possess long-term, value-generating assets with a higher return than any and all liabilities. This rule of thumb is applied to both short-term and long-term perspectives.

Liabilities

Debt is liabilities. Liabilities are accounts payable, notes payable, mortgage, bonds means that there are obligations to be made to a creditor. Debt is borrowed money (loans), promises to pay, amounts that are owed but not yet paid, obligations to provide services or products for cash already received. The borrower (debtor), in general, will repay the initial amount including a concentrated amount or rate.

In concept, liabilities can be viewed as ‘risk’. Increased debt can hinder an individual or organization from achieving sufficient cash flows, favorable interest rates, and in some cases may lead an individual or organization towards insolvency (bankruptcy).

Return = Risk + Fluctuations

The ‘free game’ regarding liabilities is to hold long-term (fixed) debt with the overall interest rate on all debt to be less than the return the organization is receiving for their asset accounts, if or when debt is necessary. If debt is preferred or needed, keep the overall debt-to-assets ratio under 30%. A debt-to-assets ratio under 20% has little to no impact on credit rating. This rule of thumb is applied to both short-term and long-term perspectives.

Equity

Equity are revenues, expenses, stock, retained earnings, credit cards, paid-in capital, owner's capital.

Revenues increase assets (net worth, or wealth). Expenses decreases assets. Increasing retained earnings display consistency and promotes financial stability for an individual or organization.

The key to equity is reducing, if not eliminating, expenses to the optimal amount. In turn, this may provide an opportunity for increased free cash flows to increase assets. In fact, paying expenses in advance can be classified as prepaid expenses which are considered assets.

Every management decision affects an individual or organization's financial capabilities. It is prudent and wise to have a good understanding of you or your organization's financial position (balance sheet).

The key to equity is to carry-over earnings from cycle-to-cycle at a stable, increasing rate while reducing expenses.

It can be argued the most efficient way to increase assets is to eliminate debt altogether and make investments in assets that produce a higher rate of return than equities.

A ↑ = L↓ + E ↕

The overall ‘free game’ is to increase assets at a rate that is higher than both liabilities and equity. If this can be done, an individual or organization will undoubtedly increase their value...or their net worth! 

3 %↑ = 1%↓ + 2% ↕

Then, it becomes a matter of preference of cashing in on the returns, allowing unrealized gains to climb, or allowing interest to be compounded!

References

Mayo, H. B. (2016). Basic Finance: An Introduction to Financial Institutions, Investments, and Management, 11th Edition. Boston: Cengage Learning.

Tracie Miller-Nobles, B. M. (2018). Financial & Managerial Accounting, 6th Edition. Pearson Education.

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Meet Nikia Smith, the Project Management Consultant driving success at Business and Wealth Generations. With over a decade of advisory expertise, Nikia orchestrates strategy and operations, spearheading growth and innovation. Beyond his professional endeavors, Nikia actively participates in his community, having served on the Board of Directors at the Project Management Institute Florida Suncoast Chapter in different roles for several years. Recognized for his contributions, he received the PMI Florida Suncoast Chapter Award in 2018 for significantly boosting membership and retention and was also selected to attend the 2019 PMI North America Leadership Institute Meeting in Philadelphia. Nikia holds a Bachelor's Degree in Management and Organizational Leadership with a focus on Project Management, alongside several business certificates from St. Petersburg College. He is also certified in CAPM and PMP by the prestigious Project Management Institute. For collaboration opportunities, reach out to Nikia at info@thebusinesswg.com.