Assets, Liabilities, And Net Worth

Written by: Frabert Ace E. Dela Cruz, Carl Angelo L. Marcelo, Pierre L. Saldajeno, and Justin Philip S. Tuazon

You've probably heard of the term "net worth". However, what is it exactly? How is this figure derived? Is it just the amount of cash one has? What does it really mean when someone has a net worth of Php 100 million? In this article, we will talk about assets and liabilities, which form the net worth, as well as net worth itself. itself.

Assets

An asset is defined as anything that has economic value or anything that will benefit its owner in the future. Assets can be sources of cash flow. For instance, cash itself, equipment (such as 3-D printers), stocks, patents, and land are all examples of assets. Assets can be owned by an individual, a business corporation, or a state.

Assets can be classified into two broad categories - personal assets and business assets. Although these two categories are technically distinct, they are very similar.

The first kind, personal assets, refer to assets that are owned by an individual. For example, the money you have right now in your wallet are assets of yours. Things like houses and lots you own and your investments (e.g., stocks and bonds) are also part of your personal assets.

The second kind, business assets refer to assets owned by business corporations. Assets to companies are those that help them maintain and even grow their businesses. Common examples of this kind of assets include materials used to produce goods (e.g., wood, flour, etc.), capital equipment (e.g., cutting machines, baking oven, etc.), and land. Other examples include patents.

Now, there are also many types of business assets, with two of the most common ones being current assets and fixed assets. Current assets refer to short-term assets, which can be converted into cash in less than a year. Examples of current assets include cash itself and inventory (raw materials or goods that are available for selling). On the other hand, fixed assets are long-term assets such as capital equipment and buildings.

Other classifications of assets include financial assets, which are investments such as stocks and bonds, and intangible assets like patents and copyright.

Liabilities

Opposite to assets, liabilities, or credit in simple terms, refer to items, services, or obligations owed to others that are needed to be fulfilled by an individual or a business firm.

Usually, a liability has 3 requirements:

1. It imposes an obligation to the borrowing individual or firm to pay back to the lender;

2. This obligation is a consequence of a past event (e.g. signed loan agreement); and

3. The settlement of the obligation needs an outflow of valuable resources.

Though we commonly associate liabilities with something bad, it can promote financial growth because it allows businesses to acquire new tools and pay for services which can promote the firm’s operations and growth, thereby increasing its profits (this assumes that the liabilities do not exceed the assets).

In an accounting balance sheet, liabilities can come into 2 forms:

1. Current liabilities, named for its duration, refer to liabilities projected to be settled or liquidated within a year from the present. These liabilities generally contain payables like taxes, wages, account payables, unearned revenues (customer deposits), unpaid accrued expenses, portions of long-term bonds that are annually paid, and other short-term commitments.

2. Long-term liabilities: refer to liabilities not projected to be settled or liquidated within a year from the present. Long-term leases, bonds, product warranties, notes payable, and pension liabilities are common examples.

Net Worth

Net worth = Assets - Liabilities

By subtracting the value of total liabilities from the value of total assets, we can obtain the net worth of an individual or company. It is a useful measure of one’s financial health at a given point in time.

A positive net worth implies that assets are greater than liabilities, while a negative net worth implies otherwise. A positive and growing net worth is often desirable since it indicates good financial health.

Net worth can be improved by either increasing assets, decreasing liabilities, or both.

In business, net worth is also called “owner’s capital” (for sole proprietorships) and “shareholder’s equity” (for corporations). It is usually found in the last section of the balance sheet. One party that is interested in a firm’s net worth is creditors. A lender or creditor uses the net worth, as well as other measures related to it, as an indicator of a company’s ability to repay its liabilities. Firms’ net worth can increase by earning profit, issuing stock, or appreciation of the company’s book value.

In personal finance, net worth is simply the residual amount after deducting liabilities (e.g., mortgages, student loans) from assets (e.g., savings account, real properties). Like businesses, an individual’s net worth is taken into account for lenders and creditors before they can make loans such as car loans and mortgage loans.

There is no one standard net worth for businesses and individuals that is considered “good.” It may vary from person to person and business to business.

On net worth

As mentioned earlier, net worth can become negative, when liabilities exceed assets. A negative net worth suggests that one should reduce their debts. It is also important to note that net worth is not the amount of cash one has.

Net worth is a useful measure of one’s financial health at a given point in time. However, aside from an instantaneous picture, net worth can provide an even more comprehensive assessment of financial health by tracking it over time. Being aware of net worth can help in making more informed and potentially better financial decisions and planning.

Conclusion

In this article, we talked about what assets and liabilities are, as well as how net worth is derived from these quantities. Remember, net worth is an important financial indicator and is much more comprehensive than just taking the amount of cash!

References

Barone, A. (2022, January 27). Asset. Investopedia.

https://www.investopedia.com/terms/a/asset.asp

Faulkenberry, K. (2012, December 17). Explain Balance Sheet: Define Assets, Liabilities, and

Net Worth - Arbor Asset Allocation Model Portfolio (AAAMP) Value Blog. Arbor Asset Allocation Model Portfolio (AAAMP) Value Blog. https://www.arborinvestmentplanner.com/explain-balance-sheet-define-assets-liabilities-and-net-worth-2/

Folger, J. (2021a, June 23). Why knowing your net worth is important. Investopedia.

Retrieved May 27, 2022, from https://www.investopedia.com/articles/pf/13/importance-of-knowing-your-net-worth.asp

Folger, J. (2021b, November 7). What is an asset? Investopedia. Retrieved May 27, 2022, from

https://www.investopedia.com/ask/answers/12/what-is-an-asset.asp

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