Determining the financial health of a company requires an accurate balance sheet and an overview of how the company generates, spends, borrows and offers money to shareholders.
Using the correct equation, an accountant can determine the total value of the business.
The accounting equation explores a company’s assets, liabilities and net worth to provide a complete picture of its financial situation.
In this article, we discuss what net worth, liabilities, and assets mean, how the accounting equation applies to business, and provide two examples of the accounting equation in action.
Why are net worth and liabilities equal to assets?
A business’s assets, or the total of all items owned by the business, have been purchased with the business’s current capital, or net worth, and debts, or liabilities. This relationship is known as the accounting equation:
Assets = Liabilities + Net Worth
It is important to understand why the company’s total equity and liabilities are equal to its assets, in order to better understand how financial resources move in a company and how the company measures them.
For this it is necessary to understand each of the terms: liabilities, equity and assets. Here are the main differences between the three:
Shareholders’ equity
A company’s equity represents the amount of capital that the company could return to its shareholders if it were to liquidate all of its assets.
Companies can determine the value of equity by subtracting the company’s total liabilities from its total assets.
Companies measure equity to provide shareholders with information about how much their stake in the company is worth in terms of equity.
Shareholders can decide to modify or maintain their positions based on the amount of value the company offers.
Passive
A company’s liabilities are its main costs to keep the business running within its industry.
A company’s liabilities can show the amount of debt it has, the profitability of its products or services, and the company’s labor costs.
Here are some common examples of business liabilities that can be included in the accounting equation:
- Long and short term debts
- Rent or lease payments
- Vehicle payments and maintenance
- Production equipment and tools
- Wages and salaries
- Tax or debt payments
- Utility costs
Active
A company’s assets are its cash or cash equivalents and any other liquid assets the company may have.
For example, a large shipping warehouse might consider its total inventory an asset, since it has monetary value and the business could liquidate it for capital if needed.
Treasury bills, investments, and other holdings are also assets. Companies measure their assets to determine profit margins, salaries and to reallocate funds in the business.
They also use the assets to demonstrate the company’s profitability to shareholders or other investors.
Assets can also be any capital owed by customers of the business for services rendered or goods sold.
This can include accounts receivable and outstanding invoices that the business converts to cash once customers complete their payments.
Purpose of the accounting equation
The accounting equation is important in determining the total financial value of a company.
While other financial measurements, such as the income statement, show a company’s financial health and profits, the balance sheet shows the company’s financial performance throughout the year.
The accounting equation uses all of the company’s financial information throughout the year to create a global summary for quick reference.
Many companies use it to top up their balance sheets and attract new investors.
How to use the accounting equation
To use the accounting equation, there are a few steps to follow. Here’s how to use this equation in your business accounting:
1. Post income, expenses and other data
The first step in using the accounting equation is to gather financial information for the year or time period being accounted for.
This includes income sheets, receipts, bank statements and any other physical or digital documents in which the company stores financial data.
Many modern businesses use accounting or bookkeeping software or spreadsheets to track expenses and assets, making the process more efficient.
Tally up all the business expenses for the year, including long-term expenses like paying off debt.
It is important to include debt in the accounting equation because it is one of the main liabilities of most companies and investors often want to know how indebted a company is before they invest.
You can also account for business income, including sales and profits from interest payments, investments, and other non-business income.
Also list the liquid assets of the business, including total cash on hand.
2. Review the balance and correct errors
The balance sheet summarizes the financial health of the company, but it is not always completely accurate. It is important to check as much of the balance sheet as possible before using the accounting equation to determine the company’s assets.
Compare receipts and bank statements with the balance to verify their accuracy. Correct any errors you find and verify discrepancies with financial reports or people in the company.
3. Use the equation to create a subtotal
Using the accounting equation, you can generate a subtotal for the company’s total assets, liabilities, and equity and make sure the two numbers match.
If you generate a different number on each side of the equation, there may be an error somewhere in the balance or a reporting discrepancy.
Once you generate and review your subtotal, you can add or subtract information after your review to get a more accurate number.
For example, if a business has $1,000,000 in assets but shareholders’ equity and liabilities equal $1,200,000, there may be an error tracking income or expenses.
4. Use numbers to make positive change
The next step in using the accounting equation is to make changes to the business to align assets, liabilities, and equity. Now you know how much money the company earns, where it comes from, what it owes and who invests.
You can determine if the company can expand or introduce new products or services.
You can also see how long-term debt is preventing the business from expanding or increasing costs, and determine if it’s time to refinance loans or reduce the total amount of debt.
Use the accounting equation
Using the accounting equation is easier when you understand what it looks like. Here are two examples of how to use the accounting equation:
Example: Groundwork Construction, LLC, estimates that it has $575,000 in total assets this year, with about $85,000 in annual expenses. The company wants to know what its net worth may be to shareholders before its initial public offering. Thus, the accountant uses the accounting equation, entering the values of the company:
$575,000 = $85,000 + X
The X represents the equity of the company. To solve this equation, the accountant would subtract $85,000 in liabilities from the company’s $575,000 in assets. The difference is $490,000, so the company has a total equity of $490,000.
Example: Bearings Tech, Inc. has launched three new products in 2020. The company wants to know the total liabilities it has for the previous year, to compare it with the previous year. This determines how much liability the company added to launch three new products. The company establishes its accounting equation:
$1,850,000 = X + $800,000
The company subtracts $800,000 of equity from the company’s total assets of $1,850,000 to determine total liabilities of $1,050,000. Using the prior year’s total liability of $750,000, the company determines that its total liability has increased by $300,000.
