The Parable of Assets, Liabilities and Equity

A young man once asked his Father, what must I do to be a successful entrepreneur? His Father looked at him and with a big smile on his face then beckoned on him to take a seat. As both men sat, his Father told him a parable. There were two women, one with a degree […]

A young man once asked his Father, what must I do to be a successful entrepreneur? His Father looked at him and with a big smile on his face then beckoned on him to take a seat. As both men sat, his Father told him a parable.

There were two women, one with a degree from a reputable University named Zeo and another named Zara who didn’t go to the University but learnt the art of trading from her mother. Zeo and Zara set out to start-up businesses in their chosen fields. Zeo was a gifted Baker and set out to start a Bakery while Zara a very good cook set out to start a Restaurant. Before departing from home, Zeo was given some money by her parents and also obtained a loan from her best friend Zikora which was to be paid up in six months. Zara’s mother applied for a six month loan from her co-operative, sold some of her possessions and gave the money she had put together to her.

Zeo chose to situate the Bakery in an upscale neighbourhood where most of the residents appeared to live healthy lives as most of them were seen jogging very early in the morning every day. She got a space in a high street shopping mall and contracted a leading interior decoration company to help with the interior and exterior design of the Bakery she named “Zeo’s”. After finishing the interior and exterior design of the Bakery, Zeo set out to buy Bakery equipment’s only to realise that she had spent more than she should have on leasing and renovating/ upgrading the space where the Bakery was situated. Instead of buying new equipment’s, she resorted to buying fairly used equipment’s. With the money she had left, she had a launch party where she and her very excited friends sang, danced and posted pictures on social media all night.

Zara elected to open her restaurant close to a major bus terminal in a densely populated part of town where hundreds of people took the bus on a daily basis. Her Restaurant named after her, served local delicacies with the option to sit in and eat or take-away. She ensured her environment was always clean and made sure her sales girl was courteous to everyone who came to buy a meal. Her investment in acquiring assets for use in the restaurant was minimal as she bought only the basics with the mind-set that she will buy more equipment’s as the restaurant grew.

Both businesses started about the same time but three months into starting the Bakery, Zeo complained that her patronage was not as she envisaged. Her friends always came around and she was more than happy to give them pastries and bread every time they were leaving and even when they decided to buy, they bought on credit most of the time. Her oven started developing problems and she was unable to produce on some days. She had issues with the service charge at the shopping mall; the management of the mall wanted to collect service fees upfront for a three months period going forward. Zeo was distraught, everything seemed to be falling apart. She had not repaid her loan, no money, no customers, faulty equipment’s and increasing administrative overheads were her new reality.

Zara was having a different experience. Her native jollof rice was the rave of the moment as customers from within and outside her locality patronized her. She employed a “pay before service” philosophy. Her sales girl did the serving while she collected the money from the customer. She had repaid the monthly instalments on the loan her mother took on her behalf as and when due. Business was really good.

The young man appeared to be enjoying the story when his father asked him if he was able to extract any lessons from the parable. As he was about to respond, his father motioned towards him and continued speaking. “To become a successful entrepreneur, you need to understand the role of Assets, Liabilities and Equity in the business” he said. He went on to explain what he meant by Assets, Liabilities and Equity. The accounting equation (Assets= Liabilities+ Equity) truly sums it all. It suggests that assets can be acquired either through liabilities (debt) or equity or a combination of both. Assets can be referred to as resources controlled by a business from which future economic benefits are expected to flow to the business. “Future economic benefits” from that definition refer to the income generated by the business and it is safe to assume therefrom that cash will flow to the business. Liabilities on the other hand can be described as a “present obligation, arising from past transactions which when settled or paid will lead to an outflow of economic benefit from the business’’. Equity can be described as an “owners claim to a business’s net assets” and net assets refers to total assets less total liabilities. Equity is sometimes referred to as the cash or idea the owner of the business makes available to start up the business.

Assets can either be acquired by way of debt (loans, borrowings from family and friends) or Equity (personal savings, inheritance, funds from partners etc). One of the principal things done with loans or equity is the acquisition of assets (note that for a start-up, debt and/or equity can also be used for set-up costs). These assets are expected to generate income or enable income generation. It is this cash that is in turn used to settle expenses that maybe incurred during the course of business or liabilities as and when they fall due. Excess cash can also be used in acquiring new assets, used for growing the business or even paid out as dividend to the owners of the business.

Looking lost, the young man asked “Father, how does all this relate to your parable”? His Father answered with the following points

1. The monies obtained by Zeo from her parents and the proceeds from Zara’s mother’s possession were equity in the business. Every start-up business needs equity as it shows a level of belief in the business idea or as some will say skin in the game.

2. The six month loan Zeo took from Zikora and the loan Zara’s mum took on her behalf from the co-operative are Liabilities. These loans have cash flow implications as principal and interest will have to be repaid based on the terms of the loan. Start-ups and small businesses are encouraged to use more of equity at the start and when the business starts generating a regular cash flow pattern, they can consider taking debt by way of loans if and only where necessary.

3. Zeo and Zara used their debt and equity differently. While Zeo used her’s for non-income generating assets leading to poor cash flows, Zara used hers wisely, spending wisely and being more deliberate about getting the proceeds of her sales.

4. To be a successful entrepreneur, you need more than talent. Zeo and Zara were gifted at what they did but the decision making required to manage a successful enterprise was evidently better with Zara.

5. Cash is the life-blood of any organization. Any business that is starved of cash will find it difficult to operate whether in the short, medium or long term. Cash is used to fund day to day operations of the business, repay loans, settle overheads, invest, acquire assets and at the right time pay dividends.

6. An understanding of your market and the interplay of product, price, promotion and place (4p’s of marketing) are as important as the talent, capital and passion any entrepreneur possesses.

The Father asked his Son, is there any other lesson you have learnt? The son replied heartily, “business thrives when friends and family pay for goods and services”.