If you're looking at a company's balance sheet, its assets essentially represent things and accounts that it owns, including cash, land and merchandise to sell. You'll also see another section listing the company's liabilities, meaning money that it owes, including long-term debt and short-term obligations like wages and office rent. The difference between assets and liabilities is the total equity, or shareholders' equity, which is what would go to the company's shareholders if it were immediately liquidated.
Finding total assets equal to the total equity in a company on a balance sheet is very rare, because almost any functioning company will have some sort of liabilities. Assets might be equal to equity in the case of a company that's essentially ceased functioning and is in the process of winding down.
Assets and Liabilities
One of the most fundamental documents in corporate finance and accounting is a company's balance sheet. This lists the assets the company owns and the various liabilities, or obligations, it has to other people and organizations.
Typical examples of assets include land and buildings the company owns, equipment such as tools or computers, inventory held for sale and cash in the bank. Assets are often divided into current assets, which can be converted into cash within a year, and long-term assets, which cannot. Assets aren't all tangible or cash in the bank: accounts receivable, meaning money owed to the company, count as assets, as do prepayments on rent or services.
Liabilities include long-term debt borrowed to finance the company, as well as more immediate liabilities such as wages owed to employees, payments owed to contractors and service providers, tax liabilities and any rent the company owes. Current liabilities, similar to current assets, are those that must be paid within a year, while long-term liabilities are due over a longer period of time.
To evaluate the health of a company, investors will sometimes look at the ratio of liquid assets, meaning cash, receivables and assets easily converted to cash, to current liabilities. If the ratio is below one, it can be a danger sign as it indicates the company doesn't have enough cash to pay its bills, although it may also be a sign of a healthy business that regularly converts sales inventory to cash.
Generally, if you are thinking of investing in a company, this will be one of many measurements you'll consider.
The difference between assets and liabilities is known as shareholders' equity or total equity. This essentially represents what portion of the company's assets belong to the shareholders, who usually get paid after the liabilities are satisfied. In theory, if a company were to be liquidated, that's what the shareholders would get paid, each proportional to their stock holdings.
It's rare for shareholders' equity to be equal to a company's assets, since it's almost impossible for a company to function without some sort of liabilities. After all, even conservatively managed companies with no debt will still have to pay bills and taxes.
If a company owes more than it has in assets, shareholders' equity can actually be negative. This can be a warning sign for potential investors, since it makes it less likely they'll actually get money back on their investment. Thanks to laws that generally limit shareholder liability in the event of a bankruptcy, shareholders usually won't actually be required to pay for those excess corporate liabilities, though they can certainly lose their investments.
The Debt-to-Equity Ratio
As the name suggests, the debt-to-equity ratio for a company is found by dividing its total liabilities by its total equity. Companies can finance growth either by raising money from shareholders or by borrowing money. If they're emphasizing the latter approach, the debt-to-equity ratio will be higher.
Companies with a higher debt-to-equity ratio may be more risky investments, but it's worth taking into account other statistics about the company's financial performance before making that decision based on one number.
- Different industries use varying levels of equity and liabilities to fund assets. Compare the proportion of a company’s assets that it funds with equity with those of other companies in its industry to determine an acceptable level.
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.