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The basic balance sheet equation is assets = liabilities + equity. The purpose of the equation is to show what the company owns, purchased on credit, or through its shareholders’ investments. The equation reflects the financial strength of your business on any given day, and whether you’ll be able to meet your financial obligations.
For some, the term “equation” might induce high school math anxiety. But as a business owner, the assets, liabilities, and equity equation is very important for understanding business finances.
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 (sometimes known as an accounting equation or equity equation), is that it’ll allow you to gauge the financial health of your business.
That’s essential to make sure you’re running your business the best way possible. Understanding your assets, liabilities, and equity can help you figure out if you’re handling your inventory efficiently, if you’re capable of paying your bills, if you can take on additional debt through a business loan, and much more.
So, let’s break down assets, liabilities, and equity in terms that actually make sense.
Essentially, the balance sheet equation displays how much your business owns (your assets), which you’ve purchased with money you owe your lenders (your liabilities) or through your principals’ own investments (your equity). The equation should balance, which makes sense: What you really own is the sum total of your net worth and what you owe. But why is this equation 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 you can to make your business grow? Of course you do.
That’s why it’s essential to not only understand the equity, assets and liabilities definition, but also how all three relate to each other. It involves 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.
Using the accounting equation to understand your business’s financial health is crucial. But before you crunch the numbers, make sure you consult two important reports: your profit and loss statement, and your balance sheet.
The first report you’ll need is your P&L, or income statement.
You probably already look at this report frequently to check up on your total revenue and expenses. At the end of the year, your total expenses are subtracted from your total income to calculate your profit. All business owners are familiar with the profit and loss equation, because it can 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. Here’s why.
The other report that small business owners need to understand is their balance sheet. It includes a summary of your 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.
The accounting equation is considered to be the foundation of what is known as double-entry accounting—which states that every financial transaction has equal and opposite effects on at least two different accounts. This should be reflected on your balance sheet (if it isn’t, speak to an accountant or bookkeeper right away to remedy this error). In other words, your balance sheet is an expanded version of the account equation: assets = liabilities + equity.
Each transaction in a double-entry accounting system has two sides. The first side of the transaction is called the debit side of the transaction. The offsetting side of the transaction is called the credit side of the transaction. Debits are recorded on the left side of your balance sheet in double-entry accounting. They always increase assets, expenses, and dividends, while decreasing income, liabilities, and equity.
Credits, on the other hand, are recorded on the right side with double-entry accounting. Credits always increase income, liabilities, and equity, and decrease assets, expenses, and dividends. Because debits and credits increase and decrease the exact opposite types of accounts, the books in a double-entry accounting system remain in balance at all times.
Before we dive into the balance sheet to calculate your accounting formula, you’ll first need to understand assets vs. liabilities, and how “equity” is defined in this formula.
An asset is something the business owns. Some common asset accounts include cash or bank accounts, accounts receivable (monies owed to you by your customers), inventory, fixed assets (buildings, machinery, or furniture), and investments. Intangible assets like patents, trademarks, or non-compete covenants count too.
Asset accounts are classified as either short term, or long term. A short-term asset means that the asset will be used, sold, or liquidated to pay for liabilities within a year; and a long-term asset won’t be used or sold within the year.
Balance sheet liabilities are what the business owes, whether to an individual, another business, or an institution, like a bank or the IRS. Some examples of liabilities are accounts payable (monies owed to your vendors), business loans, and amounts owed to customers for gift certificates or prepaid services. Liability accounts are classified just like asset accounts—either short- or long-term.
Equity can be looked at as the net worth of the business. If we rewrite the equation for the balance sheet another way, it actually makes much more sense: assets – liabilities = equity.
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.
Depending on the business entity, equity accounts can have many different names. For sole proprietors, for example, their 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).
Now that you understand the basics of this important accounting equation, let’s see what it looks like in action.
Let’s say you want to gauge the financial health of your business using the accounting equation. To start, you’d turn to your balance sheet and find the total of all your assets and liabilities for the period you are looking to evaluate. Then you would find shareholder equity and add that number to total liabilities. If you did everything right, your total assets will equal the sum of your liabilities and equity.
Let’s apply this to a real-life business situation. For the fiscal year of 2018, ABC Corporation reported total assets of $150 million, total liabilities of $60 million, and total shareholder equity of $90 million. If you subtract liabilities from assets ($150 million – $60 million), you’ll quickly see that it is the same as shareholder equity ($90 million).
For ABC corporation, the accounting equation reveals that $150 million of assets is financed by $60 million in liabilities and $90 million of shareholder equity. With this information in hand, ABC corporation can rest assured that the business transaction its carrying out are being accurately reflected in its books.
That equation you learned above—assets – liabilities = equity—is the balance sheet equation. And once it clicks for you, you can use it, along with your P&L statement, to get important information about the financial health of your company.
But that’s not the only equation that can give you insight into your business’s financial performance. Here are a few others you might want to nail down:
1. Current Ratio: total current assets ÷ total current liabilities
This ratio measures a company’s ability to pay short-term and long-term debts.
2. Working Capital: total current assets – total current liabilities
This represents the amount of capital a business has to operate the business. In other words, it answers the question: How much does my company have to invest in the business after meeting all its obligations?
3. Inventory Turnover: average inventory ÷ cost of goods sold
The inventory turnover ratio measures the number of times inventory is sold and replaced within a certain period. This indicates whether you’re being efficient with your inventory, and stocking the right products.
4. Return on Equity: net income ÷ equity
Finally, the return on equity shows how much profit a company generates per dollar of equity.
Yes, these equations require a bit more math. But beyond being essential for understanding how efficiently (or not) you’re running your business, getting the hang of these equations may actually help you make a better-informed business loan decisions—many of the financial ratios that lenders use when determining credit risk are based on balance sheet accounts. Understanding how they relate to your situation can really help you before you start to look for a business loan.
In all, the balance sheet formula (a.k.a. the accounting formula or equity equation) displays the details included on your balance sheet. But having a holistic understanding of your business’s financial health takes more than simply completing this equation. You’ll need to take a look at your profit and loss and balance sheet together—although a company may show a profit on the profit and loss statement, the balance sheet might tell a different story.
Beyond that, carrying out equations such as your current ratio, working capital formula, inventory turnover, and return on equity can help you answer crucial questions about the efficiency with which you’re running your business, and whether you need to tweak your processes to better meet your debt agreements.
So take the time to review your assets, liabilities, and equity, get into the habit of reviewing both your balance sheet and P&L statement frequently. That way, you’ll have a handle on how your business is doing at any given moment.