These three elements, assets, owners equity and liabilities, when compared to one another, show what we call the financial position of the business.
Let me give you an example...
Would you invest in the following business?
Probably not. 90% of the assets of this business will be used to pay debts in future. The equity, which reflects the net worth of the business (the real worth to the owner or owners) is only $10,000. The financial position of this business is thus poor.
What about this business – would you invest in it?
Well, in this case you certainly would be quite apprehensive about investing. The total debts of the business are greater than the assets it has to pay off these debts. As a result the owner or owners are making a loss. The owner or owners may have to fork out $20,000 out of their own pockets to pay the liabilities. Where the total debts of the business are greater than its assets, we say that the business is insolvent. This means that it cannot pay all its debts. Obviously the financial position of this business is terrible.
Now how about this business?
This business looks a bit healthier. The business can comfortably pay all of its debts. In fact, only 40% of the assets will be used up to pay the debts – 60% of the assets are really owned by the owner. The net worth of the business is $60,000. The financial position of this business is quite good.
Bear in mind that it is not always a bad thing to have debts – where you have a project that will bring you $40,000, but you need to invest $5,000 to start with (and you don’t have the money yourself), it would be a wise move to borrow the $5,000 (thereby creating a liability of $5,000 towards the bank). Maybe it takes you a year to pay the debts, which comes to $6,000 in total after all the bank charges and interest. Well, you’ve still made $34,000 from this ($40,000-$6,000). Not bad, hey?