How to Assess the Financial Health of a Company - Part I Articles | Accounting

What is meant by the financial status of a company? It shows you the total financial resources the company has as well as the claims against these assets at any given point in time. A company is therefore a unique blend of financial resources as well as claims, which are also referred to as equities. Irrespective of the type of business, it ought to have to types of equities: owners’ and creditor’s equities. Thus, Economic Resources = Owners Equity + Creditors Equities.

Assets, in accounting terms refer to the total financial resources the company has at a particular time period. On the other hand, its liabilities are the total amount of creditors’ equity which the company has to carry. Thus, the most common accounting formula or equation is Assets = Owner’s Equity + Liabilities. Like any other equation, both sides of the equation should be equal. This equation shows the financial results of daily business operations of a company.

Let us examine the two most important concepts in any business, assets and liabilities. Assets are financial resources which are expected to generate more wealth in the future. This could be real estate owned by the company which could be rented or leased out to generate income. In case the company belongs to the category of owned companies then this value is added to accounts receivable in terms of money. Yet there are plenty of assets which are intangible like copyrights, trademarks and patents which are equally valuable to any business.

What are liabilities? These are prior commitments which the company has already entered into. These can be transfer of assets to another entity, cash out flow or providing services to customers in the future. These are also known as debts of a company or the money owed by the company to others in future. All these details are noted under accounts payable. It is obvious that a company which has plenty of debts or liabilities is treated to be claims according to business law.

In case the company fails to meet its obligation to clear the debts to its creditors, law says that the credits have the right to demand sale of the company’s assets to recover the amount. The creditors yield a lot of control over the owners of the company and their dues must be paid in advance, much before the company has received any money from the market. In the unfortunate event of debts eating into the assets of a company, the owner’s equity pertains to the claim of the business owners with relation to the assets possessed by them. In other words this is the amount owed in interest or the balance resources available after deducting the amount pertaining to entity liabilities. Thus, to calculate the owner’s equity: Owner’s Equity = Assets-Liabilities.

When the owner’s equity is called in some companies as stock holder’s equity, the equation would be Assets = Liabilities +Stockholder’s Equity. Retained earnings and contributed capital are the two components of stock holder’s equity. Thus, Stockholder’s Equity = Contributed Capital + Retained Earnings.

The amount which each stock holder has invested in the company is called as the contributed capital. This is usually separated in two distinct segments named as ‘par value’ and the ‘additional paid capital’. Retained earnings are the equity amount which have been earned by the stock holders but retained for future use by the company.