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A balance sheet is a complex display of a basic equation: Assets = Liability + Equity. The purpose of the equation is to show the financial strength of your business on any given day. The balance sheet tells you how much money you have in the bank and whether you’ll be able to meet your financial obligations.
If the word “equation” induces high-school math anxiety, we get you. But as a business owner, the accounting equation for assets, liabilities, and equity is super important. And certainly not the same as the stuff from pre-calc that you never used again in your entire life, we promise.
The reason you want to know about how assets, liabilities, and equity all relate to each other, and how they come together in “the balance sheet equation” is that it’ll allow you to gauge the financial health of your business. And that’s completely essential to make sure you’re running your business the best way possible, and not letting any details slip by. (See, we told you it’d come in handy.) Knowing about assets, liabilities, and equities can help you figure out if you’re handling your inventory efficiently, or if you’re capable of paying your bills. And that’s just the start.
If you’ve taken a business class, the balance sheet equation was probably broken down for you in terms of debits and credits and double entries and… wait, what was that again? Right.
Let’s break down assets, liabilities, and equity in terms that actually make sense.
The balance sheet equation. Why’s it important, exactly?
How about a different question—is it important to know if you’re stocking the right products, or if your business is giving you a return on your investment? Do you want to make sure that you’re doing all of you can to make your business grow? Of course you do.
That’s why it’s essential to not only understand what assets, liabilities, and equities are (we’ll get to that in a few), but also how they relate to each other. We won’t lie that it’ll take a little work—and, yes, involve a little math—but it’s worth the work. Getting a grasp on these concepts will unlock important insights for you on your business’s financial health—and empower you to make the right decisions for the future.
→Too Long; Didn’t Read (TL;DR): Understanding assets, liabilities, and equity will help you understand important, particular financial insights about your business. With this info, you can make the best decisions.
Using the accounting equation to get a good gauge on your business’s financial health comes down to two reports: your profit and loss, and your balance sheet. These are are two reports that all businesses need to have have—and that they should rely on to get a picture of their assets, liabilities, and equities. You’ll need both reports to get the full picture.
The first report is the P&L, or the income statement if you’d like to call it that. You probably already look at this report frequently to see what your total sales were for the month and how much you spent in office supplies. The profit and loss report includes the total amounts recorded in your income and expense accounts.
At the end of the year, our total expenses are subtracted from our total income to calculate our profit for the year. All business owners are familiar with the profit and loss equation because it seems to give you a clear picture of where the money is coming from and where it’s being spent. But the profit and loss alone doesn’t show you everything… and here’s why.
The other report that small businesses need to understand is the balance sheet. It includes a summary of our total assets, liabilities, and equity. Many small business owners know that the balance sheet is important, but they don’t really understand what it’s telling them.
While the purpose of the P&L is to show how your business performed over a specific time period, the purpose of the balance sheet is to show the financial position of your business on any given day. The balance sheet can tell you how much money your business has in the bank and how likely it is that your business will be able to meet all of its financial obligations.
It can also tell you how much profit (or loss) the business has retained since it started.
→TL;DR: You won’t be able to get this done without your business’s P&L and balance sheet!
Go grab that balance sheet—we’re going to use it first. But… before we can use the balance sheet for analysis, we need to really understand the three types of accounts included on it! Those are assets, liabilities, and equity. Here goes.
Asset accounts are classified as either short-term (meaning they will be used up or paid within one year) or long-term (meaning it will take more than 12 months to use them or pay them back).
Liability accounts are classified just like asset accounts—either short- or long-term.
Equity accounts take the form of contributions (money invested into the company), distributions (money taken out of the company by the owners), and retained earnings (the cumulative profit or loss of the business since its inception). At the end of each fiscal year, the net profit (or loss) from the profit and loss is added to (or subtracted from) retained earnings and the amounts in the income and expense accounts reset to zero.
Equity accounts can have many different names depending on the organizational structure of a business. For example, a sole proprietor’s equity accounts are usually called Owner’s Equity for money put into the business and Owner’s Draw for money given back to the owner. And a corporation has a Common Stock account (the initial investment into the company), Additional Paid in Capital (APIC, or additional amounts invested by the shareholders), and Shareholder’s Distributions or Dividends Paid (amounts taken out of the company by the shareholders as a return of their investment or share of the company’s profits).
→TL;DR: A simple way to think about assets are what you have (like cash and trademarks); liabilities are what you owe (like accounts payable and outstanding loans); and equity as your business’s net worth. Or, your assets minus your liabilities is the value of your equity.
That equation you learned above: Assets – Liabilities = Equity? That’s called “the balance sheet equation.” And once it clicks for you, you can use it, along with that profit and loss statement, to get important information about the health of a company.
There’s a little more math involved, true, but in the end, you’ll come out with some really important numbers to help you out. Some important ratios you can use to gauge the health of your business are:
Many of the financial ratios that lenders use when determining credit risk are based on balance sheet accounts, so understanding how they relate to your situation can really help you before you start to look for a business loan.
→TL;DR: Once you have a handle on “the balance sheet equation,” you can learn a ton more about your business with important ratios. (They’re listed above!)
When you look at the profit and loss and balance sheet together, you get the full financial picture of your business. And although a company may show a profit on the profit and loss statement, the balance sheet might tell a different story. That’s why you’ll want to get into the habit of reviewing both reports frequently, and you’ll have a great handle on how your business is doing.