FRAMEWORK
Assets
Assets is the accounting name for the productive resources owned and used
by a business.
Current assets are those assets (eg. stocks) that are consumed in the daily
business of generating the income required to perpetuate the business cycle.
Fixed assets are those assets (eg. machines) that are of a permanent nature,
and provide the ability to trade.
Liabilities and Capital
Liabilities is the accounting term for the business's debts. A computer
company, say, will buy hardware stocks from a vendor and until those stocks
are paid for, the company will have a liability to the vendor (creditor).
This liability is obviously equal to the value of those same stocks that the
business will own as a current asset, prior to selling them.
Another liability that the company has, is to its owner who has provided cash
or other assets for the business to use in its operation. To distinguish
between liabilities to third parties and the liability to its owner, the
latter is referred to as the capital of the business.
Capital differs from other liabilities because it will only be repaid if the
company ceases trading. However, as in the case of third-party liabilities,
the liabilities to the owner equal the assets now owned by the company and
received from the owner, and/or acquired from the money received from the owner.
The accounting equation
The equality of capital-and-liabilities to assets is known as the accounting
equation:
| capital |
+ |
liabilities |
= |
assets |
Like any mathematical equation, the parts of the equation can be manipulated
to reveal other relationships:
| capital |
= |
assets |
+ |
liabilities |
| capital |
= |
net assets |
|
(assets - liabilities) |
The net assets of the business are referred to as the net worth, and this is
the owners' claim on the business.
The original equation is, of course, a greatly simplified representation of
reality, and as such, it can be expanded into further component parts. Current
liabilities are debts of the business that require repayment within 12 months.
Bearing this in mind, the equation can now be restated as follows:
| capital |
+ |
long-term liabilities |
+ |
current liabilities |
= |
fixed assets |
+ |
current assets |
Using the rules of mathematics again, current liabilities can be transferred to
the other side of the equation:
| capital |
+ |
long-term liabilities |
= |
fixed assets |
+ |
current assets |
- |
current liabilities |
or
| capital |
+ |
long-term liabilities |
= |
fixed assets |
+ |
net current assets |
The only difference between the two equations immediately above is the expression
'net current assets'. This represents the difference between current assets and
current liabilities, and is called working capital.
|
