As a small business owner, it’s important to understand information about your company’s finances. One important thing to look at is how much of your business assets are financed with debt vs. paid for with capital. Use the accounting equation to see the difference.
What is the accounting equation?
The accounting equation is used in double-entry accounting. It shows the relationship between your business’s assets, liabilities, and equity. By using the accounting equation, you can see if your assets are financed by debt or business funds. The accounting equation is also called the balance sheet equation.
Balance sheet equation parts
Use your business’s balance sheet to calculate the accounting equation. The balance sheet is a financial statement that tracks your company’s progress. The balance sheet has three parts: assets, liabilities, and equity.
Assets are items of value that your business owns. For example, your business bank account, company vehicles, and equipment are assets.
Liabilities are debts that you owe to others. For example, your payables are liabilities.
Business equity shows your ownership in the business. If you are a sole proprietor, you hold all the ownership. If there is more than one owner, you split the equity. Calculate equity by subtracting your assets from liabilities.
What is the basic accounting equation?
The accounting equation requires liabilities and equity to equal assets. The following is the accounting calculation:
Assets = Liabilities + Equity
Each side of the accounting equation has to equal the other because you must purchase things with either debt or capital.
Equity has an equal effect on both sides of the equation. If you know any two parts of the accounting equation, you can calculate the third.
You can write the accounting equation with the liabilities by itself:
Liabilities = Assets – Equity
Or, you can write the accounting equation with equity by itself:
Equity = Assets – Liabilities
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Accounting equation examples
The following examples are connected to the same business. Take a look at how different transactions affect the accounting equation. Then, see the business’s balance sheet at the end of this section.
You’re starting a business selling printed T-shirts. You save for a year before opening and contribute $10,000 to the new company. By doing this, you increase your business’s assets and owner’s equity by the same amount:
$10,000 Assets = Liabilities + $10,000 Equity
Let’s say that after you form your company, you need to buy equipment to print the T-shirts. You purchase $2,000 of the equipment on credit. In this situation, you gain a liability (debt) and an asset. Your assets and liabilities increase by $2,000, so the equation looks like:
$2,000 Assets = $2,000 Liabilities + Equity
As your T-shirt company grows, you get an order for 50 shirts from a customer. The customer pays $10 per shirt, or $500 total. You gain an asset and equity from the transaction:
$500 Assets = Liabilities + $500 Equity
Example balance sheet:
You will record each of the above transactions on the balance sheet. The assets should equal the liabilities plus equity. Here is what the balance sheet looks like:
Here is the full accounting equation for this example:
$12,500 Assets = $2,000 Liabilities + $10,500 Equity
Expanded accounting equation
The expanded accounting equation shows the relationship between your income statement and balance sheet. You can see how equity is created from its two main sources: revenue and owner contributions.
This the expanded accounting equation:
Assets = Liabilities + Owner’s Equity + Revenue – Expenses – Draws
Revenues are what your business earns through regular operations. Expenses are what it costs to provide your products and services.
Certain patterns occur as figures in the expanded accounting equation change:
- Revenue increases owner’s equity
- Expenses decrease owner’s equity
- Owner’s draw decreases owner’s equity
The two sides of the equation must equal each other. If the expanded accounting equation is not balanced, your financial reports are inaccurate.
Why the accounting equation is important
The accounting equation can give you a clear picture your business’s financial situation. You must calculate the accounting equation to read your balance sheet. The accounting equation helps you understand the relationship between your financial statements. In a Fundera article, Heather D. Satterley, founder of Satterley Training & Consulting, LLC, explains:
The purpose of the balance sheet is to show the financial position of the business on any given day. The balance sheet can tell you how much money the business has in the bank and how likely it is that the 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.
By using the accounting equation, you can see if you can fund the purchase of an asset with your business’s existing assets. And, the equation will reveal if you should pay off debts with assets (like cash) or by taking on more liabilities.
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