Financial stability in business requires an understanding of accounting fundamentals and their practical application. The accounting formula is a cornerstone of sound bookkeeping practice. The accounting formula will show you how to check your assets, liabilities, and equity, so keep reading to learn more.
Assets, Liabilities, and Equity
In order to use the accounting equation, you must first be familiar with the components of the balance sheet that are input into the equation. A balance sheet is a financial statement that reports on the financial status of your business. The asset section, the liability section, and the equity section make up the balance sheet.
- Your company’s assets include everything of value that it possesses, it could either be “current” or “non-current.” An organization will benefit from a non-current asset for more than one fiscal year after purchasing it, while a current asset will only be useful for the current fiscal year.
- Payables, or debts, to third parties are what we call liabilities. Liabilities include things like company credit card debt, rent, and tax obligations. Don’t add back in taxes you already paid when calculating your debts.
- Equity is a representation of a person’s stake in a company. One person or entity owns 100% of a sole proprietorship. When a company has more than one owner, that equity is distributed among those owners. Include the total value of all stakeholder investments in your equity. To determine your company’s equity, deduct your total assets from your total liabilities.
What role do these fundamentals play in balancing the books?
The Basic Equation of Accounting
Assets = Liabilities + Equity
The accounting equation is the same thing as the accounting formula or the balance sheet equation, both of which are terms used by accountants.
This helps you keep track of your assets, liabilities, and equity and alerts you when there has been an error in your accounting. Every increase in assets must be counterbalanced by an equivalent increase in either liabilities or equity (or both).
In this example balance sheet, assets are listed on the left and equity and liabilities on the right, as dictated by the accounting equation.
| Assets | Liabilities and Equity |
|---|---|
| Current Assets Investments Property, plant, equipment Intangible assets Other assets |
Current liabilities Long-term liabilities |
| Total liabilities + Owner’s equity | |
| Total Assets | Total liabilities + Equity |
Let’s look at a live example.
| Assets | Liabilities and Equity |
|---|---|
| $10,000 in Cash $5,000 in Equipment $8,000 in Electronics for employees |
$10,000 in Loans $13,000 in Stock (company owners and investors) (Equity) |
| Total assets | Total Liabilities and Equity |
| $23,000 | $23,000 |
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Why Is It Important?
It is crucial to the success of your business that you understand how to accurately account for your assets, liabilities, and equity.
In order to get a clearer picture of your company’s financial future, you should compare the snapshots provided by the accounting equations based on these three accounting categories. This will help you choose between an unsecured business loan and a more conventional bank loan.
So, how do you compare these figures? Well, you can do so by creating a balance sheet. In a perfect world, your balance sheet would always be balanced if your accounting was as accurate as you’d like to think it is. That’s why your assets and your liabilities plus your equity should always balance out.
The term “double-entry accounting” is used to describe this method because every transaction has an effect on two distinct ledgers. Every time you buy something, it becomes an asset and a liability, and every time you sell something, it decreases in value but adds to your equity.
Calculating the Equity Equation of Accounting
This is the equity equation, also known as the “assets and liabilities equation.”
Assets – Liabilities = Equity
Stock, or a shareholder’s percentage ownership in a company, is the most common form of equity.
Similarly, bear in mind that the liabilities’ equation is:
Liabilities = Assets – Equity
You can’t get a handle on your company’s finances unless you know the difference between assets, liabilities, equity, and how to use them. Even if money is coming in quickly, debt could still build up. For a better understanding and capital assistance, reach out to EBoost Partners to build a safe and secure business.
What Are Assets, Liabilities, and Equity: FAQs
The accounting equation is important because it ensures accuracy and balance in financial records, helps assess a company’s financial position, and provides the basis for preparing financial statements and making informed decisions.
The three fundamental accounting equations are:
1. The Accounting Equation (or Balance Sheet Equation):
Assets = Liabilities + Equity
This equation represents the fundamental principle of double-entry bookkeeping. It states that the total assets of a company are equal to the sum of its liabilities and equity. It ensures that every financial transaction affects at least two accounts and maintains balance.
2. The Income Statement Equation (or Profit Equation):
Revenues – Expenses = Net Income (or Net Loss)
This equation calculates the net income or net loss of a company by subtracting expenses from revenues. Revenues are the income generated from the sale of goods or services, while expenses are the costs incurred in the process of generating that income.
3. The Cash Flow Equation:
Cash Inflows – Cash Outflows = Net Cash Flow
This equation focuses on the cash flow activities of a company. It compares the cash inflows (such as cash received from sales, loans, or investments) to the cash outflows (such as cash paid for expenses, loans, or investments) to determine the net cash flow. It helps assess the liquidity and financial health of a business.
Assets, liabilities, and equity are key components of a company’s financial structure. Here’s a brief explanation of each:
1. Assets: Assets are resources owned by a company that have economic value and can be used to generate future benefits. They can be tangible (physical assets like cash, inventory, equipment, or property) or intangible (such as patents, trademarks, or goodwill). Assets are typically categorized as current assets (short-term) or non-current assets (long-term).
2. Liabilities: Liabilities are the obligations or debts of a company to external parties. They represent the company’s financial responsibilities and can include loans, accounts payable, accrued expenses, or long-term debt. Liabilities are categorized as current liabilities (short-term) or non-current liabilities (long-term).
3. Equity: Equity, also known as shareholders’ equity or owner’s equity, represents the residual interest in the assets of a company after deducting liabilities. It reflects the ownership interest of shareholders or the owner in the company. Equity includes the initial investment made by owners and retained earnings, which are the accumulated profits or losses of the company over time.
The accounting equation (Assets = Liabilities + Equity) illustrates the relationship between these three components, highlighting the balance between a company’s resources (assets) and its financing sources (liabilities and equity).
The basic equation of accounting is known as the “Accounting Equation” or the “Balance Sheet Equation.” It is as follows:
Assets = Liabilities + Equity
This equation represents the fundamental principle of double-entry bookkeeping, where every financial transaction affects at least two accounts and must maintain balance. Assets are the economic resources owned by a business, liabilities are the obligations or debts of the business, and equity represents the owner’s or shareholders’ interest in the business.
