What Is A Balance Sheet Equation?
Definition: A Balance Sheet Equation is simply an accounting equation that seeks to ensure the sum of a company’s or business assets is equal to the sum of liabilities and capital invested. The accounting equation uses the double-entry principle, whereby for every debit entry into a balance sheet, there is an equal credit entry.
The balance sheet equation acts as the most basic building block of accounting. It also forms the building block for the double-entry accounting system. In its simplest form, the equation shows what a company or business owns what it owes, as well as owners and shareholders stakes in the company.
Companies and businesses boast in their ranks assets, liabilities as well as owners and shareholders’ equity often represented in a balance sheet. A balance sheet, in this case, acts as a financial statement that shows what assets the company owns as well as its liabilities and shareholders’ equity at a given point.
A balance sheet is often used among other financial statements such as income statement and cash flows statement to calculate financial ratios and ascertain the financial health of a firm.
Balance Sheet Equation Components
The basic balance sheet equation formula consists of three main components: Assets, Liabilities, and owners’ equity.
Assets = Liabilities + Owners Equity
In a balance sheet, the left side outlines a company’s asset, while the right-hand side showcases liabilities and shareholders’ equity. In the listing, more liquid accounts such as inventory cash, as well as trade payables, appear at the top followed by illiquid accounts such as equipment and long-term debt.
Assets
Assets, in this case, refer to resources owned by a company or business used in the production of goods and services. Being resources, they can be tangible such as plant, machinery, and equipment or intangible such as patents and trademarks. In a balance sheet, assets are listed from top to bottom based on their liquidity.
Liabilities
Liabilities refer to obligations that a company must meet to stay afloat. Liabilities are simply debts that a company must pay outsiders and include things like bank loans salaries and accounts payable. Such claims also show what creditors own in the company or business in the form of debts that must be paid.
Liabilities are shown before the owner’s stake in a balance sheet equation because they must be paid first before the owner’s claims. Current liabilities are those that must be offset within one year, while long-term liabilities can take more than one year.
Owners/ shareholders equity refers to the amount of money invested by shareholders or an owner into a business. Equity mostly shows the amount of money contributed by the owner or shareholders for a stake in the company.
Under equity, you may also find retained earnings, which arises whenever a company decides to keep net income after paying dividends.
Balance Sheet Equation Example
When a business is starting, the owner may decide to invest $2000 as the initial capital.
In this case, the business assets would be worth $2000. Liabilities would be zero, as the business has not borrowed any amount. Likewise, the shareholder’s equity would be $1000.
The balance sheet equation will in this case be
Assets ($2000) = Liabilities (Zero) + Owners Equity ($2000)
A balance sheet equation will always be in balance because every accounting entry will always have an impact on assets as well as liabilities.
Balance Sheet Equation Uses & Importance
A balance sheet equation provides an easy way of comparing a company’s assets with its current liabilities. In this case, assets should always be greater than current liabilities if a company or business is to cover its short-term obligations.
The balance sheet equation also makes it possible to see how a company or business is leveraged. By comparing dent to equity, one can ascertain leverage on the balance sheet.