The Difference Between Financial Assets and Liabilities

Simply put, assets are worth something and liabilities are not. Assets add financial value to a company's balance sheet whereas liabilities take away financial value. Nevertheless, both assets and liabilities are important because they facilitate business operations and profitability. In other words, both assets and liabilities serve useful business purpose(s).

A good rule of thumb in terms of business operations is to never have more liabilities than assets. That is to say the current ratio, which is assets/liabilities should have a value of around 1, however a current ratio of 2 may be more conservative and safer. Knowing how much liability to take on should ideally be weighed with earnings forecasts, interest rates on liability if any, and opportunity cost of not taking on additional financing for project development and/or operations.

Classification of assets and liabilities

Although assets and liabilities are both often divided into "short term (current)" and "long term (fixed)" categories on corporate financial statements, their value to a company and actual function is different. Moreover, what is commonly known as a short term or current" is liquid i.e. convertible into cash in the case of assets and payable on a short time scale in the case of the liabilities. Long term assets and liabilities differ from short term liabilities in that the assets are more difficult to convert into cash i.e. non-liquid, and the liabilities have a longer repayment schedule.

Examples of current assets include cash accounts, accounts receivable (if accrual accounting is used), and in stock inventory. Long term assets include items such as property, and equipment that cannot be quickly be sold. Similarly, short term liabilities may include accounts payable, and short-term debt instruments such as vendor credit accounts. Longer term or fixed assets can include commercial mortgages, machinery debt or other debt that is payable in full over a longer term time horizon.

Distinguishing the advantages of assets and liabilities

Another way to distinguish the difference between assets and liabilities is to understand the difference in advantages between the two. Moreover, if liabilities had no advantages, it is probable businesses would not bother with them at all as owing money in and of itself is not often perceived as financially favorable. The following lists illustrate the advantages of both assets and liabilities.

Advantages of Assets:

• Provide liquidity for a business

• Reserve assets allow for future investment opportunities

• Assets can be used as collateral for liabilities

• Can improve financial metrics i.e. business performance as measured by financial statements

• Are an essential part of business operations

It is clear from the above points, assets are essential to a business operation because they provide financial leverage, soundness, opportunity, and liquidity in addition to being a simple function of the fact that businesses usually must have assets of one kind or another to operate be it equipment, transportation, office supplies etc. The advantages of liabilities are different from those of assets as shown below:

Advantages of Liabilities:

• Finance project development

• Facilitate cash flow

• A necessary component of accrual accounting

• Make possible additional business opportunities

The effect of assets and liability on business performance

Knowing how much assets to have in either short term or long term form can affect business performance just as ascertaining the ideal amount of debt to maximize operational success is important. There are a few ways this can be achieved including ratio analysis, market research and business assessment. Each of these methods helps determine the "ideal" level of assets and liabilities necessary to achieve business objectives, financial stability and optimal profit margin.

To illustrate the above, too much stock inventory can be an asset that costs money to keep because storage costs increase overhead expenses that cost a business money. Therefore, assessing how much inventory is needed can help reduce expenses thereby preserving business worth. Another example is how too much debt can end up being not worthwhile. That is to say, if debt is taken on to finance a business project at a cost of 8% annualized and the project only yields a return of 7% of the investment, that debt is failing to pay off. Many different dynamics and relationships between assets, liabilities and business performance exist within businesses and that is why it is helpful to understand the differences between assets and liabilities.

To recapitulate, assets are the items in a business that have value such as cash, vehicles, money to be received, property etc. whereas liabilities are often debt instruments such as loan payments, credit accounts, mortgages etc. Both assets and liabilities are important to a company's success because they both help finance business activities which are aimed at generating profit.

A business without liability may be more difficult to operate due to limited cash flow and may miss opportunities to generate greater income whereas a business with liabilities may operate more successfully, and make possible transactions that would otherwise be impossible ex. credit shipping orders of inventory. Thus, assets and liabilities can be distinguished in three ways, 1) their numerical effect on business valuation both physically and on paper, 2) unique advantages to a business and 3) different influences of assets and liabilities on business performance. While on the surface, assets and liabilities are quite easy to define, they do tend to have subtle yet important impacts on business that help further distinguish them beyond the traditional meanings.

Sources:

1. http://www.allbusiness.com/accounting-reporting/assets/1257-1.html
2. http://ezinearticles.com/?The-Importance-of-the-Balance-Sheet-as-a-Financial&id=513212
3. http://www.stock-market-investors.com/stock-investing-basics/importance-of-current-assets-and-current-liabilities.html