Assets and liabilities

The profit and loss tells you how a period went. It cannot tell you what a business, or a person, is actually worth. For that you need two new words. Assets are what you own. Liabilities are what you owe. Subtract one from the other and you get the most honest number in finance.

Assets: things with value that you own

• Cash, in accounts or in hand.
• Money owed to you by customers who have not paid yet.
• Equipment and tools: a laptop, a coffee machine, a drying rack.
• Stock waiting to be sold, and for bigger players, property and investments.

Notice that money owed to you counts as an asset. It is value you have earned and can expect to collect, which is exactly why good books track it instead of letting it be forgotten.

Liabilities: claims other people hold on you

A liability is any amount you are obliged to pay someone else: a supplier's unpaid bill, a loan, a credit card balance, tax owed but not yet paid. Liabilities are not automatically bad. A loan that bought a useful asset can be a smart move, as the loans topic covered. They simply must be counted, because they are claims on your assets that will be collected.

The snapshot: a balance sheet

List the assets, list the liabilities, subtract, and you have built a balance sheet. The difference is called equity for a business and net worth for a person, and it answers the question where do we stand better than any bank balance can. Someone with $8,000 in the bank and a $12,000 credit card debt is worth less than someone with $500 and no debts. The bank balance says otherwise. The balance sheet tells the truth.

This is also why profit and worth are different measurements. A profitable month raises your equity. But equity can also change without any trading at all, for example when equipment ages and loses value, or a debt is forgiven. The two reports work as a pair, and reading them together is what reading a business means.

Why it always balances

There is a deeper reason the two sides of a balance sheet relate so neatly, and it is worth seeing once. Everything a business owns had to be paid for somehow, and there are only two sources: money the owner put in or earned and kept, which is equity, and money someone else provided, which is a liability. So every asset is claimed either by an outside party or by the owner, which means assets always equal liabilities plus equity. Rearrange that and you get the version you already have: assets minus liabilities equals equity. The sheet is not balancing by luck. It balances because every dollar of value has an owner.

Build one with illustrative numbers to feel it move. A weekend baking hustle has $180 in its account, $40 owed by a customer who took two cakes on credit, and an oven timer and tins worth $120, which is $340 of assets. Against that it owes $60 to the supermarket for flour and butter bought on a tab, and nothing else, so liabilities are $60. Assets of $340 minus liabilities of $60 leaves equity of $280. Now watch what happens when the customer pays the $40: cash rises by $40 and the amount owed to the hustle falls by $40, so the assets total does not budge and the equity stays at $280. Getting paid does not make you richer. It only turns one kind of asset, a promise, into another, cash.