Assets And Liabilities: Differences, Types And Relationship

Companies maintain balance sheets to understand which items increase their cash inflow or cash outflow. This information helps management understand the current financial conditions of a firm. If business accounting interests you, learning how a company's finances can benefit stakeholders and allow them to assess their investments and returns from can help you understand this field more clearly. In this article, we define assets and liabilities, discuss the difference between them, their different types and the relationships between them in accounting practices.

What Are Assets And Liabilities?

Assets and liabilities are components in accounting that help businesses and professionals identify income-producing items and debts. Assets benefit a company economically and help businesses deliver their services. They may help companies manufacture goods and provide services in the present or future. In contrast, liabilities are obligations that a company owes to other companies or persons.

Related: Assets Vs Income: Definition And Differences (With Types)

Assets Vs Liabilities

A company's balance sheet reflects its various liabilities and assets. Each has a role in the growth of the company but serves different purposes. The following lists some differences between the two terms:

Financial implication

Businesses thrive when their assets are greater than their liabilities, as it ensures that the companies have enough cash to pay their debts. If the liabilities are greater, a company may be in financial trouble. Liabilities are important for any business's financial growth. These may be credit taken to purchase tools or materials for the business that may aid in its future growth. It is important to make calculated decisions to ensure that the liabilities of a business remain less than the assets.

Related: How To Read A Balance Sheet (Components And Template)

Depreciation

Assets break down over a period as they may get used in the daily operations of businesses, such as manufacturing or administration. These make assets prone to depreciation over time. In contrast, liabilities are consistent in their value and do not depreciate.

Related: 5 Depreciation Methods (With Definitions And Formulas)

Cash flow

Assets result in an inflow of cash into the company's accounts. They increase the balance of cash that is available to the company. Liabilities result in an outflow of cash and cause a decrease in the company's cash balance.

Related: Format Of A Cash Flow Statement (With Methods And Examples)

Types Of Assets

Several factors affect the categorisation of assets, including convertibility, physical existence and usage. The following lists different types of assets:

Assets based on convertibility

Some assets may get exchanged for cash. This conversion of an asset to cash may occur over some time. Depending on these factors, an asset may be short term or long term. These assets include the following:

Current assets

Current assets, also known as liquid assets, may convert into cash or its equivalents within a year. It may occur through the sale of inventory or account payments. Companies use current assets, such as cash, office supplies and marketable securities, for their daily operations. Some examples of current assets are short-term deposits, accounts receivable and inventory.

Fixed assets

Fixed assets, also known as capitalised assets, help companies produce their goods and services for future income. These assets are long-term investments that may depreciate over time. Companies may convert fixed assets into cash in the event of an emergency or financial downfall. The different types of fixed assets include equipment, furniture, land, patents and trademarks.

Assets based on physical existence

Assets may exist in different forms and benefit the company. These assets include the following:

Tangible assets

Assets that physically exist are tangible assets. Companies require these assets for their daily operations, such as machinery, office supplies or cash. These assets are things that people may see, feel or touch.

Intangible assets

Assets that do not physically exist are intangible. It may be difficult to assign a monetary value to these assets. In several cases, they may be more valuable than tangible assets, as they may directly influence the business and its existence. Some examples of intangible assets include copyrights, permits, brand equity and intellectual property.

Assets based on use

An asset serves a purpose in any company. It helps add value to and aid in a company's financial growth. The following is the classification of assets based on their use in an organisation:

Operating assets

Operating assets help businesses conduct their daily operations. These assets are important for the company to provide their product or service and improve their growth. Some examples of operating assets are buildings, copyright, equipment and cash.

Related: What Is Working Capital Management? (Importance And Ratios)

Nonoperating assets

Nonoperating assets may not have a use in the daily operations of a company. These assets may serve as an additional source for the business to increase its revenue. Vacant land, interest from fixed deposits or short-term investments are examples of nonoperating assets.

Types Of Liabilities

The categorisation of liabilities relies on how early a company may settle them. The different types of liabilities include the following:

Current liabilities

Current liabilities are those that a company may settle within less than 12 months. These liabilities directly affect the working capital of the business, as they are necessary to perform everyday operations. These liabilities include interest payable, bills payable and short-term loans.

Related: What Are Current Liabilities? (And How To Record Them)

Non-current liabilities

Non-current liabilities are those that a company may settle over a longer duration than 12 months. These liabilities are quantifiers of the company's financial stability and affect the asset-to-liability ratio. These liabilities include loans, bonds and derivative liabilities.

Contingent liabilities

Contingent liabilities may occur in the future as a result of a probable event. Companies may include these liabilities in their accounting books if the chances of it occurring are greater than 50%. Contingent liabilities include lawsuits payable, warranty liability and investigations.

Relationship Between Assets And Liabilities

Liabilities and assets are important components in accounting. The following are some ways in which they may relate to each other:

Equity

Correlating a company's current liabilities and assets is important to understanding the liquidity in the business. A company's worth, or equity, requires understanding its total assets and total liabilities. The equity of a company has different meanings depending on its size. In a small company, the equity, referred to as owner equity, affects the partners or business owners. In a larger company, the equity, referred to as shareholder equity, involves a large company answering to its investors. The following is how understanding assets and liabilities helps in the calculation of equity:

Equity = total assets − total liabilities

Accounting formula

The accounting formula, or the balance sheet equation, helps understand the total assets of a company. It establishes a relationship between assets, liabilities and equity. The formula serves as a simple method to recheck a company's bookkeeping. The following is how you determine the accounting formula:

Assets = equity + liabilities

Working capital ratio

The working capital ratio is key to understanding the financial state of a company. It helps businesses assess their ability to settle financial obligations using their assets. The following is the calculation of the working capital ratio:

Working capital ratio = current assets − current liabilities

Operating cash flow ratio

Companies may settle their liabilities with the cash revenue the business generates. The operating cash flow ratio helps firms understand the cash flow and determine the number of times a company may be able to settle its current liabilities. The following is how companies calculate their operating cash flow ratio:

Operating cash flow ratio = operating cash flow / current liabilities

Debt-to-equity ratio

The debt-to-equity ratio is an important accounting formula for investors and shareholders who plan to engage in long-term investments with the firm. It helps investors understand the company's potential to distribute dividends periodically. A lower ratio confirms this potential, while a higher one showcases that the company relies on borrowed funds. The following is how you may calculate the debt-to-equity ratio:

Debt-to-equity ratio = total liabilities / equity of the shareholders

Total-debt-to-total-assets ratio

A company may leverage its financial obligations to increase its capacity to grow. A low ratio implies lower dependence on financial obligations and greater use of existing capital to finance daily operations. This means that a low ratio indicates stable finances. The following is how you may calculate the total-debt-to-total-assets ratio:

Total-debt-to-total-assets ratio = (short-term debt + long-term debt) / total assets