Balance sheet components: Liabilities and Equity.

We said earlier that the balance sheet shows what the company owns and owes. What the company owns are called assets and we have seen the various types of assets that a company holds. Now what the company ‘owes’ is categorized into two – (1) Liabilities and (2) equity. So in another way, the total of what the company ‘owes’ shows how the company found money to buy the assets !!. Let’s dig into the topic:

  • Section 2- Equity and Liabilities. What the company owes is classified into Equity and Liabilities. Fine. But what’s the difference between the two? The difference is – Equity is that part of funds that the company raised by issuing shares. It also includes that amount the profits that has been made in all the past years and kept accumulated without paying it to the share holders.
  • So, you and I, who gives money to the company by subscribing to it’s IPO forms the ‘Equity’. To that extend, we are the owner’s of the company. The equity ownership that we get can be sold in the secondary market if there are takers for it. That organized place where we sell equity ownership is called the stock market.
  • Liabilities are outside borrowings, usually listed on the balance sheet from the shortest term to the longest term, so the very layout tells you something about what’s due to be paid and when.
  • Anything a company owes to people or businesses other than its owners is considered a liability. There are two types of liabilities – Current liabilities and long term liabilities. In general, if a liability must be paid within a year, it is considered current. This includes bills, money you owe to your vendors and suppliers, employee payroll and short-term loans. A long-term liability is any debt that extends beyond one year, such as a mortgage loan or a term loan availed by the company to purchase machinery.
  • Apart from long term and short term liabilities there’s one more category called ‘contingent liability’. Contingent liabilities are estimated payments that the company may have to make if a future event takes place. For instance, suppose the excise authorities have imposed a heavy levy on the company, which has been disputed by the company on some justifiable grounds, but the authorities have gone on appeal against the company, it is a contingent liability. In the normal course, the company does not expect the liability to crystallize, but if the court verdict ultimately goes against the company, it will have to meet the liability. This is a contingent liability.
  • Contingent liabilities are not ‘actual liabilities’ and hence will not be displayed in the balance sheet figures. It will be shown as a ‘note’ below the balance sheet.That’s why ‘notes to balance sheet’ assume lot of importance to an analyst.

So, logically, Equity (+) liabilities should be equal to Total assets. This will be true at any point of time. How and why it will always happen is something an accounting student should be learning , not you. Since your aim is to study and analyse the balance sheet to make investment decisions, a through knowledge of the frame work given in this session should be sufficient.

You may like these posts:

  1. Balance sheet components: Assets
  2. Balance sheet : what is it?
  3. The components of financial statements

2 Responses to “Balance sheet components: Liabilities and Equity.”

Shanthanu

March 25, 2012 at 10:45 am

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Seemanth

May 23, 2012 at 4:25 pm

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