Q: How Do I Use the Accounting Equation in My Business?

Assets, liabilities, and equity tell you what your business has, what you owe, and what you’ve invested—respectively. These three concepts make up the accounting equation, and they lay at the heart of all small business accounting. 

When you’ve got a firm understanding of assets, liabilities, and equity, you’re able to see how your business stands financially. That means you can prove its solvency—which is essential for getting a loan, bringing on investors, or even selling your business.

Here’s everything you need to know about assets, liabilities, and equity—and how to use the accounting equation to fine-tune your bookkeeping.

What are assets, liabilities, and equity?

Once you’ve got a firm grasp of assets, loans, and liabilities, and organized bookkeeping to track them, you can use them to:

  • Keep on track with debt repayment
  • Create financial projections for the future of your business
  • Plan how or when to sell company stock

The first step is understanding assets—what your company owns.

What are assets?

Assets are anything valuable that belongs to your company. On the books, assets often show up as:

  • Accounts receivable: Payments customers or clients owe you.
  • Cash: Money in the bank.
  • Inventory: The total cash value of everything in inventory.
  • Property and equipment: Equipment and real estate you depend on to do business. 

There are two types of assets—current assets, and fixed assets.

  • Current assets include cash and anything you can convert into cash within one year—like inventory.
  • Fixed assets include anything more difficult to liquidate—like real estate or intellectual property. 

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It’s important to understand the assets your business holds, because those assets are the raw material you have to work with. Looking at your assets is one of the ways in which lenders and investors judge the financial health of your business.

What are liabilities?

Liabilities are debts. If you owe someone money, and you haven’t paid them yet, it’s recorded on the books as a liability.

Liabilities can show up as:

  • Accounts payable: Money you owe to suppliers or contractors.
  • Bank loans: The loan principal you owe the lender.
  • Salaries and wages payable: Money you need to pay employees.

Like assets, liabilities fall into two categories: Current, and fixed.

  • Current liabilities are debts you expect to pay off within the next year.
  • Fixed liabilities are debts that will take more than a year to pay off. 

When you add these two categories, you get your total liabilities. 

It’s important to get a detailed rundown of your liabilities, so you know what you owe and when. Balance sheets are useful for this—more on them shortly.

What is equity?

Usually, when people think of equity, they think of stock—shares in a business. But that’s just one kind of equity. 

Equity includes:

  • Preferred stock: Like regular stock, but giving the owner priority when it comes to distributing dividends.
  • Capital: Whatever remains of the initial investment used to start a business.
  • Retained earnings: Profits the company holds onto, for investing in business activities.

You calculate your equity with the following equation:

Equity = Assets – Liabilities 

For instance, if you hold $10,000 in assets, but owe $3,000 in debt, your equity is worth $7,000.

What is the accounting equation?

At the heart of all accounting activities, we find the accounting equation. Essentially, it’s an inversion of our equity calculation from above:

Assets = Liabilities + Equity

Simple, right? This equation is key to understanding how the different parts of your business relate, and how to check for errors in your bookkeeping

For a more detailed calculation, you can use the expanded accounting equation. It does the same thing as the basic accounting equation, but with the option to insert more information about you finances:

Assets = (Liabilities + Startup Capital + Revenues) – (Expenses + Owner’s Draw)

How do I use the accounting equation?

Let’s say you invest $10,000 to open an online used book shop. Right off the bat, you know your equity consists of that $10,000 in the form of capital. And, since your liabilities total $0, your assets are also $10,000.

Example #1: Buying inventory

You go ahead and spend $3,000 on books—your starting inventory. So your equity is now equal $7,000.

But what are your assets worth? We use the accounting equation to find out:

Assets = $3,000 + $7,000 

So, your assets are still $10,000.

But wait—didn’t you spend $3,000 on books? True, you did. But that value doesn’t leave the company. It just changes from being $3,000 in cash to being $3,000 in inventory.

On the books, we’d see $3,000 moving from the “Cash” account to the “Inventory” account.

A more accurate depiction of your assets might be:

Assets

$7,000 in cash

$3,000 in inventory

Liabilities

$0

Equity

$10,000 in total stock

Example #2: Borrowing money

You decide your bookstore need some extra startup capital to put into advertising, so you take out a $2,000 loan.

That $2,000 gets added to your cash account as an asset—but it also gets added to your loans account as a liability.

So, your books look like this:

Assets

$9,000 in cash

$3,000 in inventory

Liabilities

$2,000 in loans

Equity

$10,000 in total stock

So, that loan you took out increases your assets, but doesn’t change your company’s equity.

How do I track assets, liabilities, and equity with a balance sheet?

A balance sheet is a financial statement that tells you what your company holds in terms of assets, liabilities, and equity. 

Produced from transactions recorded in your general ledger, it’s one of three essential balance sheets that let you measure your company’s performance. (The other two are income statements and cash flow statements.)

A monthly balance sheet for your bookstore would look something like this:

Balance sheet for period ending October 31, 2020
Assets
Cash$9,000
Inventory$3,000
Liabilities
Loans$2,000
Equity
Capital$10,000

Now that you understand assets, liabilities, and equity, it’s time to get hands on with balance sheets so you can track each of those elements. Our guide to balance sheets has everything you need to jump in. 

For support with your bookkeeping and small business finances, check out Bench

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