The most fundamental rule of the double-entry accounting system is the principle of “Assets=Liabilities + Equity.” Assets are cash or cash equivalent instruments, liabilities are debt instruments, and equity translates to assets if all liabilities are paid off. A simplistic compilation will assert that assets are equity if liabilities are reduced. A balance sheet, with its various categories such as Current vs. Non-current assets, Current vs. Non-current liabilities, and Shareholders’ Equity , serves as a complete representation of the equation “Assets=Liabilities + Equity.” This equation is used generally to gage the “financial health” and “financial well-being” of a company. An argument presented is restricting this equation’s simplicity to financial markets would be a significant disservice as a deconstruction using tangible topics can help mold that equation to serve on a personal finance basis.
The simple algebraic equation clarifies that if liabilities are kept significantly down, assets are virtually equity. The execution of such a mindset can create better investment strategies even for the smallest of the investor. The most basic version of an asset and liability for an average individual is a source of income and a credit card, respectively. A significant portion of an individual’s earnings tenure is spent in this cycle of earning enough to pay off any debts incurred through purchases. Some individuals are better at maintaining a balance between spending and earnings, whereas others not so much. A 2019 report titled U.S. Financial Health Pulse: 2019 Trends, by the Financial Health Network, highlighted that 19.7% of people with household incomes from $30,000 to $59,999 said that they spent more than their income and that 55% of people aged 26-49 say they do not have enough savings to cover three months of living expenses in 2019 .
The chart below reflects data made available from the Bureau of Labor Statistics. Upon inspection, it can be understood that annual median weekly earnings for individuals between 25-34, 35-44, and 45-54 have only increased by 0.14%, 0.12%, and 0.13% respectively from 1984 to 2019. Even though the Net Change in Total Assets and Net Change in Total Liabilities indicates that more Americans hold Assets than Liabilities, a granular inspection suggests otherwise. The spread between assets and liabilities for 35-44 and 45-54 is least significant, and the age 25-34 is more significant. Another identifiable characteristic is how the Total Liabilities curve not until very recently has it been successfully dwarfed by the Total Assets curve in the Net Change in Total Assets vs. Liabilities chart. 2020 data, when made available, might distort the progress made in the last six years.
It is short-sighted to say if one cut down their liabilities, an increase in assets would increase equity. Some liabilities, such as home mortgages, student loans, are not so quickly reduced and can take years, sometimes decades, to redact. Not all liabilities share comparable properties of interest, so time plays a factor against holding huge portions of liabilities. Growing assets in the form of payroll are essential to keep up with growing liabilities, but the equation’s equity portion is sometimes ignored or forgotten. As of March 2018, “the access rates for defined contribution only plans were 31 percent for part-time workers and 58 percent for full-time workers in private industry” . Access to defined contribution plans or 401k was not as automatic as one would imagine. A category discussed thoroughly in financial literature is that of Retained Earnings. “Retained Earnings is the amount of net income left over for the business after it has paid out dividends to its shareholders” . A defined-contribution plan can be correlated to an individual’s retained earnings since a healthy retained earnings allow the business to be more flexible in its endeavors. The lack of easy access to defined contribution plans makes it difficult for an individual to grow their retained earnings. Therefore, increasing equity takes a different approach. Increasing equity takes a stubborn application of determination and substitution concerning the general principles of “Money.”
Economics teaches us that Money has three functions: 1) A Medium of Exchange, 2) A Unit of Account, and 3) A Store of Value . It is inferred that equity is an expression of a store of value, a value that is both personal and exercisable. Growing equity is not limited to the scope of personal finance, so restricting ourselves to a limited approach is unnecessary. Multiple environments view the growth in equity as an essential dimension since it allows for the proper execution of assets. It provides a great sense of comfort, knowing that there is enough equity in the arsenal to offset any liabilities if the assets cannot cover the outcomes. Biology can serve as a novel reference in developing a mindset on equity/capital building. Our biology dictionary teaches us that the bigger tend to perform better against the smaller. In the book, Animal Weapons: The Evolution of Battle by Douglas J. Emlen, Emlen evaluates weapons in animals. Instead of assessing inter-species duels, Emlen considered intra-species duels. The intra-specie contest between dung beetles that lived underground fighting over reproductive rights was given special consideration—a win in those battles derived from having a more powerful weapon. Emlen says, “These are contests of strength and the beetles with the smaller weapons get pushed out of the burrow, and they leave – they lose in the reproductive battle. They fail to acquire access to the female” . By building on these weapons, beetles are not only able to better defend their territory; they are better able to create a façade that enables them to deter competition. Mr. Emlen continues, “Almost all of the ‘battles’ end up resolving themselves before they escalate into a dangerous battle — because literally sizing up the weapons side by side is enough to resolve it” .
The case of the beetle allows us to examine assets and equity in a similar fashion. A beetle’s horn is both a form of asset and equity. It is an asset when used to ward off opponents, whereas it is a form of equity when used as a deterrent. Like the horn of a beetle, a defined contribution plan or retirement plan is a financial weapon available on an individual scale. A concerted effort building that financial weapon shall provide a great deal of flexibility. It is incredibly difficult to build equity if the relationship between assets and liabilities is tenuous. Instead of looking at equity building as a thing of the future, thinking of equity as just a metamorphosis of assets shall help in better application. Building equity is a patient and challenging task. It takes time and effort. A defined contribution plan offered from the workplace is ideal since it allows us to automate actions. If a program isn’t available, seeking an appropriate program is vital, since the lack of participation in one only weakens the relationship between assets and equity. The simplest and easiest way to build equity Is to create an umbrella. An umbrella consisting of both liquid and illiquid properties such as emergency savings, ownership of stocks or bonds, and a defined contribution plan. Restricting Money to one’s wallet’s confines is a gross underutilization of its properties since Money shouldn’t just be moved between Assets and Liabilities. The equity component of the equation must be given equal importance.