Assets, liability, and equity are the three components of a balance sheet. In order for the balance sheet to be considered “balanced”, assets must equal liabilities plus equity. These three categories allow business owners and investors to evaluate the overall health of the business, as well as its liquidity, or how easily its assets can be turned into cash.
The Accounting Equation
It’s a big name for a simple-looking formula (Seriously, doesn’t “the accounting equation” just sound important?). But the accounting equation plays a major role in understanding how to read your balance sheet.
Assets = Liabilities + Equity
To understand the accounting equation, it’s important to remember what the goal of a balance sheet is. The balance sheet, unlike the income statement or other financial reports, is a snapshot of your business in a specific moment. While the income statement shows how well your company did or didn’t do over a period of time, the balance sheet simply asks, “So what?”
Maybe you had a bad quarter and missed your revenue goals. So what? How did it affect the health of your company overall? The balance sheet will tell you that.
To put the accounting equation into the simplest terms, think of the left side of the equation as everything your business possesses. The right side of the equation tells you who owns it—you or someone else. For example, when you buy a new car, you get to drive it around, but until you pay it off entirely, you own some of it (equity) and a bank owns some of it (liability). What a balance sheet does is show you all the component parts of your business and then break down who owns what—and what you’re on the hook for.
Let’s break down each part of the equation in more detail.
Assets mean anything that a company possesses. This doesn’t necessarily mean that the company owns those things, simply that they have them in their possession. A balance sheet is often shown in two columns, and you’ll find assets listed in order of liquidity in the left column.
At the top of the assets list on the balance sheet are anything that could be easily liquidated. This includes cash and other cash equivalents.
These cash amounts are usually followed by assets that the company is owed, but are not in their possession yet. Think accounts receivable where outstanding invoices and payments will translate to cash in the coming months. As a rule of thumb, any assets that could be turned into cash within a year are considered current assets.
Toward the bottom of the asset list are Property, Plant, and Equipment. These are the company’s assets that would be difficult to liquidate quickly. You may have several delivery vehicles in your possession, for example. It’ll take some effort to sell them if you need to.
The reason assets are subdivided into categories based on how easily they can be liquidated is to show anyone interested in your books (read: lenders or investors) how able you are to pay off debts and liabilities. If all of your assets are tied up in property and equipment and you have very little cash on hand, that could signal potential cash flow problems.
Liabilities mean everything that the company owes to other people. Think accounts payable and credit card balances. This could also include health insurance liability or benefits. These are the part of the business that you don’t own outright so you’re on the hook to pay someone else.
Taking your credit card bill as an example, you can assume that you purchased something with your card that you now possess—an asset. Just because you have that asset, it doesn’t mean that you own it yet. First, you have to pay off that credit card bill.
Just like assets, any liabilities that you’ll need to pay off within a year are called current liabilities. Separating current liabilities from long-term liabilities like loans and other long-term debt allows business owners to more effectively plan for short-term obligations.
Comparing current assets to current liabilities is called the current ratio. Learn more about it and try the free calculator here.
This is where having a thorough understanding of your assets is helpful. If your liabilities have gone up considerably, ask yourself if you currently have enough easily-accessible assets like cash to pay them. If not, you’ve got some decisions to make to increase your cash flow.
Equity shows the assets that the company owns outright. If you were to sell all your assets and pay off your liabilities, the owner’s equity would be what’s left. It shows retained earnings and, if the company is publicly traded, common stock information. It’s the exact opposite of liabilities because it shows you what is yours to keep as a company.
There’s no perfect balance of liabilities and equity. It may depend on the type of business you’re building or the stage you’re in. Startups with funding may have a lot of cash, but they also usually spend like crazy, driving up their liabilities in the name of future growth and long-term equity. Small businesses looking for steady growth, on the other hand, may pay close attention to their cash assets and retained earnings so they can plan for big purchases in the future.
The Accounting Equation & Bookkeeping
So how exactly do these numbers magically appear on the balance sheet? Yes, a great deal of the work is handled behind the scenes thanks to accounting software, but it does start with a basic understanding of double-entry accounting, which says that every business transaction will impact at least two accounts.
Even though no one is really writing down debits and credits in ledgers anymore, you’re still following the same process. Every time you purchase or sell something, you need to classify that transaction, and that classification will impact two accounts on your chart of accounts (maybe more).
Think about it. If you sell a pen, you lose that pen from your inventory and you gain some cash.
If you buy a pen, you lose a bit of cash but now you’ve got a fancy new pen.
If you buy a machine that makes pens, you gain a super useful machine that will help you make money, but you probably spent some cash on a down payment and might also owe a bank some money for helping your finance it.
In order to keep the accounting equation balanced, you must use debits and credits to reflect what happened and to show how the component parts of your business have shifted—even if it’s as trivial seeming as buying a pen.
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