Balance Sheet

Relationship between Assets, Liabilities and Owners’ Equity

Assets are resources of the firm which are acquired from funds provided by outsiders, known as liabilities and funds provided b y owners, known as owners’ equity.

TA = TL + OE

where TA is total assets, TL is total liabilities and OE is owners’ equity.

Owner’s equity is the firm’s remaining resources (assets) after the obligations of outsiders (liabilities) have been taken care of. Net asset can be defined as the difference between total assets and total liabilities. Thus: NA = TA — TL. Therefore, NA = OE.

That is, the net assets and owners’ equity are always equal. This relationship is an equality of values, not an identity of concepts. Owners’ equity is a claim against the firm’s assets, which can be computed by calculating net assets.

The changes may be summarized as follows:

  1. An increase in net assets will result in an increase in owners’ equity. Net assets will increase: (i) if assets increase while liabilities remains unchanged or they increase less than assets increase; (ii) if assets decrease while liabilities decrease more than assets do; or (iii) if assets remain unchanged while liabilities decrease.
  2. A decrease in net assets will result in a decrease in owners’ equity. Net assets will decrease (i) if assets decrease while liabilities remain unchanged, or they increase or decrease less than assets decrease; (ii) if assets increase while liabilities increase more than assets do; or (iii) if assets remain unchanged while liabilities increase.
  3. If net assets remain unchanged, owners’ equity will also remain unchanged. Net assets will remain unchanged; (i) if both assets and liabilities remain unchanged; (ii) if both assets and liabilities increase by the same amount; or (iii) if both assets and liabilities decrease by the same amount.

NFA + CA = LTL +L CL + OE; where NFA is net fixed or long term assets, CA is current assets, LTL is long term liabilities, CL is current liabilities and OE is owners’ equity.

It can be rearranged as, NFA + (CA — CL) = LTL + OE of NFA + NCA = LTL + OE.

The difference between current assets (CA) and current liabilities (CL) is called net working capital (NWC) or net current assets (NCA). NWC or NCA is that portion of current assets which is not financed by current liabilities; therefore, it must necessarily be financed by long —term funds. Bank credit is an important component of current liabilities that finances current assets. But it is a current liability that does not arise directly form the firm’ operations. Accounts payable and bills payable and various types of accruals arise spontaneously out of the firm’ operations, and are therefore called spontaneous current liabilities.

The difference between current assets and spontaneous current liabilities (that is, current liabilities less bank credit) may be referred to as net working capital gap (NWCG) or operation capital. NWCG must of necessity be financed by bank borrowing (BB) and long-term funds. That is, NFA + NWCG — BB = LTL + OE; or, NFA + NWCG = BB + LTL + OE; Where BB is bank borrowing for financing current assets not covered by spontaneous current liabilities. The concept of NWCG is useful financial planning. There should exist some stable relationship between sales and NWCG of a firm which operates in more or less the same line of business. If this relationship is known for a given level of estimated sales, the requirement for NWCG can easily be computed.

Capital employed (CE) is defined as a net fixed (long-term) assets plus net current assets (CE = NFA + NCA); this also implies that capita employed equals to long-term funds (CE = LTL + OE). The alternative definition of capital employed is total interest-bearing debt (i.e., long-term debt plus bank borrowing) plus owners’ equity (net worth). From asset side it means, net fixed or long-term assets plus net working capital gap (CE = NFA + NWCG). Since bank borrowing does not arise directly form the operations of the firm, and that it has to be raised externally at a cost, it is more logical to use the second definition of capital employed for analytical purposes.

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