Liability vs Equity
At the year end, organizations prepare financial statements that represent their activity for the specific period. One such statement that is prepared is the balance sheet that includes a number of items such as assets, liabilities, equity, drawings, etc. The following article discusses two such balance sheet items; equity and liabilities, and clearly explains the similarities and differences between the two.
What is Equity?
Equity is a form of ownership in the firm and equity holders are known as the ‘owners’ of the firm and its assets. Any company at its stage of start-up requires some form of capital or equity, to begin business operations. Equity is commonly obtained by small organizations through the owner’s contributions, and by larger organisations through the issue of shares. Equity may act as a safety buffer for a firm and a firm should hold enough equity to cover its debt.
The advantage to a firm of obtaining funds through equity is that there are no interest payments to be made as the holder of equity is also an owner of the firm. However, the disadvantage stands that dividend payments made to equity holders are not tax deductible. There is also a considerable benefit and risk to shareholders who holds equity in a firm. In the event that the share price fluctuates, the value of shares can appreciate over time and the shareholder might be able to sell their shares at a capital gain (higher price than the price at which shares were bought) or the share prices may fall and the shareholder may suffer a capital loss.
What is Liability?
Liabilities are recorded in the company’s balance sheet and are divided into long and short term depending on the length of time of the liability. Long term liabilities are owed by a firm for more than one year, and short term liabilities are for less than one year. Examples for liabilities include payments to be made to creditors, bank over drafts, accrued rent, accrued electricity, and other amounts that are owed by the firm. Liabilities will help a firm obtain benefits now for which payment will be made in the future, and this will allow a firm to expand and continue business activities even if they cannot pay for it currently. It is important for a company to keep its liabilities under control and to maintain sufficient assets to cover the amount of liabilities so that in the event of liquidation the firm will have enough assets to pay off their obligations.
Liability vs Equity
Both liabilities and equity are important components in a firm’s balanced sheet. The accounting equation clearly shows the relationship between liabilities, assets and equity. The equity (or capital) in a firm is equal to the difference between the value of its assets and liabilities.
Equity and loans can serve the same purpose by funding an investment or project. However, equity is different to liabilities because liabilities represent an obligation that must be met by the firm. On the other hand, equity represents the amount of funds invested in the firm which can be either owner’s contributions or shareholder’s investment in the firm’s stock.
Summary
Difference Between Liability and Equity
• Both liabilities and equity are important components in a firm’s balanced sheet.
• The accounting equation shows that the equity (or capital) in a firm is equal to the difference between the value of its assets and liabilities.
• Equity is a form of ownership in the firm and equity holders are known as the ‘owners’ of the firm and its assets.
• Liabilities are amounts that are owed by the firm. Long term liabilities are owed by a firm for more than one year, and short term liabilities are for less than one year.