Should your company invest in new equipment this year? It’s crucial to understand the asset-liability-equity formula, known as the balance-sheet equation, and how it can help you make informed decisions for your small business.
Learn how to track the financial health of your business using this easy formula.
The Relationship Between Assets, Liabilities, and Equity
All three terms — assets, liabilities and equity — are interconnected. To buy an asset (such as new office equipment), you’ll need your equity (money in the bank) or a loan (liability) or a combination of both. Once you’ve made your purchase, then you add the total to the asset category and also under liabilities and equity. Doing so raises the value of your assets along with your equity or liability figures. Regardless of the amounts you add to each section, both sides of the equation always balance.
Understanding how these three elements interact can help you make data-driven choices for your small business.
Assets are the sum of short-term (current) and long-term (noncurrent) resources owned by your business. Assets include your inventory, the money customers owe you (accounts receivable) and investments. They also include fixed assets and intangible assets:
- Fixed assets. Buildings, furniture, office equipment and machinery.
- Intangible assets. Patents, trademarks and customer lists.
In the asset-liabilities-equity equation, your company’s total assets equal the sum of your liabilities and equity.
Current Assets vs. Noncurrent Assets
You can further break down your list of assets by determining which are current and which are noncurrent. This is important to know because your current assets pay off short-term debt and serve as collateral for loans.
Current assets are anything that could be sold or liquidated to pay the bills in a short time frame. This could be a short-term investment such as a certificate of deposit (CD) coming due or inventory that’ll get used or sold within a year.
On the other hand, noncurrent assets, also called long-term assets, are those that you’ll hold onto for a year or longer. It’s difficult or impossible to liquidate these resources in less than a year. Examples of noncurrent assets include office furniture, long term investments such as bonds, and intangible assets.
Liabilities are something most business owners are familiar with: debt. When you purchase a product or service, you’re obligated to pay for that purchase. If you use a loan or credit card, you’re responsible for paying the debt off.
Examples of liability include money owed to vendors from your accounts payable list along with debts to creditors, such as credit cards and bank loans. Depending on your business or situation, liabilities may consist of debts to the Internal Revenue Service (IRS), prepaid services for customers, or outstanding obligations such as gift cards.
Current vs. Noncurrent Liabilities
Similar to long- and short-term assets, liabilities fall into two categories. Any debt that you expect to pay off this year is called a current liability. Along with short term debts or obligations coming due within a year, current liabilities may include:
- Monthly operational costs such as rent or your electricity bill
- Payments to suppliers
- Employee wages
- Quarterly taxes
Noncurrent or long-term liabilities include loans that’ll take you more than a year to pay off. These liabilities may consist of long-term leases or mortgage payments, expensive equipment purchases with a longer payoff time frame or even pension obligations. For businesses that offer product warranties, such a guarantee is considered a noncurrent liability.
Equity is the sum of your total assets, including any income earned or saved in your accounts, minus the total of your debts. The equity definition can vary depending on if it’s owner equity or shareholder equity. However, in the business world, equity is your net worth or your working capital.
To figure out your equity, you add your debts and the total value of your assets. Then subtract the two numbers to find the difference. That’s what your company is worth. It also gives banks an idea of your financial condition and may benefit you if you choose equity financing for your business.
What Is the Balance-Sheet Equation?
This simple formula can help you track your company’s financial condition. It looks like this:
The Balance-Sheet Equation
Assets = Liabilities + Equity
Note: You can substitute the word capital for equity and call it the asset-liabilities-capital equation. Others use the terms accounting equation or equity equation. Every transaction gets added or subtracted to both sides of the formula — which is why it should always balance.
The Importance of the Balance Sheet
Your balance sheet gives you a snapshot of your financial strength and ability to meet financial obligations. This isn’t only for your benefit: Stakeholders, investors and financial institutions look at the balance sheet to determine your financial credibility. It’s also essential for double-entry accounting, which is a type of checks-and-balances system where every transaction is recorded in two separate accounts.
If you want to finance a loan, then you’ll need a profit-and-loss (P&L) statement to show your revenue.
Your balance sheet lists every asset and liability, broken down by current and noncurrent categories. Each type of account, such as inventory or investments, has its own line on the balance sheet. Not only can you glance at the final number to see where you stand, but you can see how that breaks down by section.
With your balance sheet, you can check where you stand financially any day of the week. This information is crucial for making sound business decisions.
On the left side of your balance sheet, list all of your company’s assets, categorized by current and noncurrent holdings. Input totals for each section and end with a grand total of all of your assets at the bottom.
On the right side, list your liabilities. Again, separate these according to current and noncurrent liabilities. Tally the numbers up and move on to your equity. Combine your company’s earned and retained income to determine your total capital.
Next, you’ll use your assets-liabilities-equity equation. Add together your total debts and your equity. Insert this number at the bottom. When you’ve accurately tracked your transactions, these two final numbers will be equal.
Calculating the Accounting Equation
When calculating the accounting equation, remember to add your transaction to both sides of the formula. Start with your balance sheet and the asset liabilities equity equation in front of you.
Assets = Liabilities + Equity
For example, if you’re starting with no debts and $500 in your business bank account, then this is how the equation looks:
$500 = $0 + $500
If you decide to purchase a new desk for $300, but want to put $200 on your company credit card and use $100 from your business account, then we add that $300 to both sides of the formula.
$800 = $200 + $600
Your desk is both an asset and also part liability and part equity.
Once you have a balance sheet in place, you can quickly add up the numbers at any time to get a clear understanding of your company’s financial condition. Having this information on hand helps you make reliable business decisions.