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Assets, Liabilities and Equity

5:07

The accounting equation states that there is an equilibrium between assets, liabilities and equity. In this video we’re going to discover what each of those categories mean and how we break them down in our daily accounting practices.

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    In one of our previous videos I mention that accounting

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    essentially boils down to the accounting equation,

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    which states that the total value of a firm's assets

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    equals the sum of its liabilities and equity.

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    Now, let's take a look at each of these categories and what they mean.

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    First up we have assets.

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    In its simplest terms, an asset is an economical resource

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    that you own that is capable of generating some value for you.

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    Everything from cash to machines to even intangible items like patents

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    are considered assets, because they bring in money to the company.

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    Assets are either current or fixed.

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    A current asset means that the asset will be consumed within one year.

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    This includes things like cash, accounts receivable, and inventory.

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    Fixed assets are those that are intended to provide value for longer than a year

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    and includes things like equipment and real estate.

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    At Shirts for Mike, our current assets include cash in the bank,

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    payments for our t-shirt orders, or accounts receivable,

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    and our inventory of t-shirts.

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    Our long-term assets or fixed assets are just our computers for now.

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    We do have an office space, but we're renting it out so it doesn't count as a fixed asset.

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    It's considered a current asset.

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    Now, if we owned the office and its life was longer than a year,

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    then we'd count it as a long-term asset.

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    Also, because we outsource the printing of the shirts,

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    we don't own any of the equipment involved.

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    Again, it does not count as a long-term or fixed asset.

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    Now, we will dig deeper into specific asset categories later on.

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    For now, just now that an asset is something that provides value to your company.

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    On the other side of the equation we have liabilities.

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    Liabilities can be thought of as the opposite of assets.

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    A liability represents a company's debts or any other legal obligations

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    that arise in the due course of business.

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    While an asset generates a value for a company,

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    a liability results in the transfer of this value in the form of money, goods, or services.

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    Like assets, liabilities are also broken down into current and long-term liabilities.

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    Current liabilities are debts payable in 1 year,

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    like short-term debts, accounts payable, and so on.

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    Long-term liabilities or non-current liabilities include long-term debt, bonds,

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    and long-term lease obligations.

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    Now, you might tend to think that liabilities are all bad, and this is not true.

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    Sure, liability is a debt obligation, and it's not good to owe people a lot of money,

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    but some debt is good.

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    Debt can be used to fund growth.

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    Here at Shirts for Mike we want to print and ship all the shirts ourselves,

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    but that means we need to buy some expensive equipment that we can't afford to right now.

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    By taking out a loan, we could fund out growth and increase our revenues.

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    We could then pay back the loan in the future.

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    Without this loan, we would have to slowly accumulate

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    enough cash in the bank to fund our growth.

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    Too much debt is bad, though, so try to keep a good balance.

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    The second category on the right-hand side of our equation

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    is stockholder's or owner's equity.

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    Unlike assets and liabilities, which are further broken down into numerous categories,

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    stockholder's equity simply represents the amount of funds contributed by the owners

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    plus any money that you put back into the company to help it grow.

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    This money you put back into the company is more formally known as retained earnings.

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    Another way of thinking of it is that owner's equity is the claim on assets

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    after all liabilities are paid spread among all the shareholders.

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    You can see this relationship in the accounting equation itself.

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    Rearranged, the equation becomes owner's equity equals assets minus liabilities.

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    Now, equity can be negative if total liabilities exceeds total assets.

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    In good times, after all the liabilities have been paid off,

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    the remaining positive proceeds can be distributed among shareholders

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    or put back into the company.

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    If liabilities exceeds assets, then the proceeds from assets are used to pay off creditors first.

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    Then shareholders, in order of priority.

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    Preferred shareholders get paid first, all the way down to common stockholders last.

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    Assets, liabilities, and equity are all recorded on a company's balance sheet—

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    an important financial statement that companies prepare to provide information to shareholders.

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    Separating these categories lets investors quickly see how much debt you have

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    relative to equity.

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    They can also drill down and see the breakup for current and long-term assets and liabilities

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    and how this affects the company's future.

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    Now, assets and liabilities are much more complex than the simple definition we've given them,

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    but it'll do for now.

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    We'll drill down and talk about individual categories later on.

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    So, for now just remember assets equals value, liabilities equals debt,

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    and the positive proceeds of assets left over after all liabilities have been paid off, equity.

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    Next up, we'll look at one of the most important, if not the most important,

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    asset to a startup—cash and its relevance in day-to-day business.

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