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Assets, Liabilities, and Equity

Assets, Liabilities, and Equity:andnbsp;

Lets start with the fundamentals. All basic securities can be summed up in what is known as the Fundamental Equation of Accounting: Assets andndash; Liabilities = Equity. Lets walk through each piece of this equation to understand it more thoroughly.andnbsp;

First, we have assets. Basically, an asset is anything that has real economic value. There are two major types of assets: tangible assets, which are assets that you can touch and feel, like real estate or inventory. There are also intangible assets, like the brand name of a company, like Coca Cola. Coca Colaandrsquo;s brand name is recognizable, it helps bring in customers and revenues. When you buy a can of coke, you know what youandrsquo;re getting. You can expect a certain level of quality, and youandrsquo;re willing to pay for that. The brand recognition has value, and therefore, the brand is an asset.

Next, we have liabilities. Liabilities are debts owed to creditors. One example of a debt is a purchase made on credit. Lets say I run a car manufacturer, and Iandrsquo;ve just agreed to purchase 1,000 tons of steel. But I didnandrsquo;t pay for the steel in cash; instead, I bought it on credit. This credit is now a liability.

But the biggest corporate liability is debt in the form of bonds. Companies issue bonds to finance the growth and development of new assets. These bonds are liabilities of the company.

Finally, we have the difference between assets and liabilities, which is net equity. This is what the company is worth, after accounting for all debt. Equity is divided up into shares of the company's stock. When you hear about andquot;shareholdersandquot; of companies, they are the owners of these equity interests.

Over the long run, the value of equity stocks is directly tied a company's profitability. A companyandrsquo;s profitability is its ability to grow its assets faster than its liabilities. This is an important concept, and is best illustrated with an example.

Lets start with a profitable manufacturing company. In year 1, this company has $300MM in assets (brand, real estate, cash, etc), and $200MM in liabilities (credit and bonds). Therefore, its net equity is $100MM.

The company wants to open a new manufacturing plant, but it doesnandrsquo;t have the money. So it decides to issue $100MM in bonds to finance the project. The project is a huge success, and at the beginning of year 2, the new plant is an asset worth $200MM.

So in year 2, the companyandrsquo;s assets have grown from $300MM to $500MM. The liabilities have also grown from $200MM to $300MM. But the assets have grown more than the liabilities. The company is profitable, and as a result, the net equity has increased from $100MM to $200MM.

Lets now take a look at our unprofitable company. In year 1, they are exactly the same: $300MM in Assets, $200 MM in liabilities, for a total of $100MM in net equity. This company is in the pharmaceutical industry, and wants to develop a new drug. The company issues $200MM in bonds to finance the project. But the drug is a failure, and only generates $100MM in value.

In year 2, the companyandrsquo;s assets have grown from $300MM to $400MM. But the liabilities have increased from $200MM to $400MM. Therefore, the equity is now worth 0. The failed unprofitable project completely wiped out the equity of the company.

I hope this helps you understand the basic concepts behind assets and liabilities, and why equity is important. Building your own equity is one of the most important keys to financial success, and stocks have historically been an excellent tool to accomplish this goal.

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Article Source: Articles For Knowledge Sharing

About the Author

Kanjoh has several financial videos to help you learn about equity and debt investing and financial planning. There are also a number of powerful stock trading resources and software platforms online. Highly recommended is Stock Assault, a powerful online software giving you the tools to start trading effectively. 

by: Sathvik

Html View | Print View Total views: 71 Word Count: 615 Date: Mon, 19 Oct 2009 - 0 comments

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