When Liabilities are Greater than Assets?
Asset Deficiency is the circumstance which company’s liabilities greater than total asset. It sounds impossible as we know that Asset equal Liabilities plus Equity, which is the accounting equation. This situation happens when company keep making loss so the retain earning become negative. The accumulated loss is greater than common share and company keep borrowing money instead of inject new capital. So at a certain point, the equity section become negative and liabilities exceed total asset.
It is the situation which give a warning sign to the managements and other users related to company’s financial health. The public listed company may be force to be delisted from capital market due to the Asset deficiency. The company may default on its obligation and go bankrupt as the assets cannot cover the liabilities. They can not continue the operation as it keeps making a loss. There are a slice chance of company can recover from such a stressful situation.
Example of Liabilities Exceed Assets
A group of investors start ABC Company with $ 500,000 of share capital and Loan from bank $500,000. We assume that company start with 1,000,000 from loan and capital. The company making loss for a few years and didn’t recover. The loss of each years can be found below:
|Year||Net Profit (Loss)||Retained Earning|
As we can see, the company need to spend cash to operate which making loss. Assume the company purely use cash to pay, there is no accounts payable and accounts receivable.
- 1st year: company lose $ 200,000 so the asset (cash) also decrease $ 200,000
- 2nd year: company lose $ 300,000 so the asset (cash) decrease $ 300,000
- 3rd year: company lose $ 100,000 so the asset (cash) decrease $ 100,000
By the end of 3rd year, company asset decrease to 400,000 due to accumulated loss of 600,000 since 1st year. However, liability remain the same at 500,000. If we look at the accounting equation:
Asset = Liabilities + Equity
$ 400,000 = $ 500,000 + ($500,000-$600,000)
$400,000 = $500,000 – $100,000
$400,000 = $400,000
At the end of 3rd year, the company’s asset less than the liabilities. In this example, we are trying to illustrate the reason which lead one company up to this situation.
This is the bad situation which company never wish to face, it can force management to close down the company. The company can file for bankruptcy, liquidate and go out of business. Liquitdate mean they are selling the assets to settle the liability, it will not even cover lialbitiies. It means shareholders will get nothing from the company.