Intro

I'm currently taking a finance course. The math isn't harder than multiplication but some concepts are a bit tricky. Here are the concepts that had me stuck, and how I understood them.

Lazy man's summary

Assets = everything the company has.
Liabilities = things owned by others.
Capital = things owned by us (shareholders).
If the company has something, someone had better own it. Thus,
Assets = Liabilites + Capital

Assets = Liabilities + Capital
This above equation doesn't seem right. I like

Capital = Assets - Liabilities

better, it is easier to understand. Even though the equations are equivalent, It doesn't seem that you should add your liabilities -- aren't they always a bad thing?

My intuition is this. Assets (the left hand side) is everything the company owns. The right hand side is who it belongs to (more specifically, the right hand side is the value of what the owners have). Liabilities are what the company owes to others (i.e. belongs to someone else), and capital is what part of the company belongs to you (or the shareholders). The two sides must always balance -- if the company has an asset, it must belong to someone.

As an example, suppose your company is worth $100, and you own the entire company. You have the equation

Assets = Liabilities + Capital

100 = 0 + 100

There are no liabilities. The company is worth $100, and since you own it all, your capital is $100. Now, suppose we borrow $150 from a bank:

Assets = Liabilities + Capital

250 = 150 + 100

The company now has $250. The $150 is really part of the bank -- the bank will get it back eventually. We still own our original $100, so the capital stays the same.

The key to this is double-entry bookkeeping. Whenever assets goes up, either liabilities or capital must go up as well. It is not just because of the equation. It is because when the company gets money, that money belongs to someone. That person's ownership of the company increases in value.

Suppose a fire destroys our building, worth $50. The new equation is

250 - (50) = 150 + (100 - 50)

200 = 150 + 50

Notice that the capital decreased, not the liability. The bank's share does not decrease because of the fire loss - our share does. As far as the bank is concerned, it owns $150 worth of the company. Because we owned the building, when it was lost, it came out of our capital.

I hope this helps: Assets = everything the company has. Liabilities = things owned by others. Capital = Things owned by us. If the company has something, someone had better own it.