Assets, Liability, Equity: The Balance Sheet Equation
A balance sheet is a complex display of a basic equation: Assets = Liability + Equity. The purpose of the equation is to show the financial strength of your business on any given day. The balance sheet tells you how much money you have in the bank and whether you’ll be able to meet your financial obligations.
If the word “equation” induces high-school math anxiety, we get you. But as a business owner, the accounting equation for assets, liabilities, and equity is super important. And certainly not the same as the stuff from pre-calc that you never used again in your entire life, we promise.
The reason you want to know about how assets, liabilities, and equity all relate to each other, and how they come together in “the balance sheet equation” is that it’ll allow you to gauge the financial health of your business. And that’s completely essential to make sure you’re running your business the best way possible, and not letting any details slip by. (See, we told you it’d come in handy.) Knowing about assets, liabilities, and equities can help you figure out if you’re handling your inventory efficiently, or if you’re capable of paying your bills. And that’s just the start.
If you’ve taken a business class, the balance sheet equation was probably broken down for you in terms of debits and credits and double entries and… wait, what was that again? Right.
Let’s break down assets, liabilities, and equity in terms that actually make sense.
Why Do You Need to Know About Assets, Liabilities, and Equity?
The balance sheet equation. Why’s it important, exactly?
How about a different question—is it important to know if you’re stocking the right products, or if your business is giving you a return on your investment? Do you want to make sure that you’re doing all of you can to make your business grow? Of course you do.
That’s why it’s essential to not only understand what assets, liabilities, and equities are (we’ll get to that in a few), but also how they relate to each other. We won’t lie that it’ll take a little work—and, yes, involve a little math—but it’s worth the work. Getting a grasp on these concepts will unlock important insights for you on your business’s financial health—and empower you to make the right decisions for the future.
→Too Long; Didn’t Read (TL;DR): Understanding assets, liabilities, and equity will help you understand important, particular financial insights about your business. With this info, you can make the best decisions.
The Two Important Business Reports You’ll Need
Using the accounting equation to get a good gauge on your business’s financial health comes down to two reports: your profit and loss, and your balance sheet. These are are two reports that all businesses need to have have—and that they should rely on to get a picture of their assets, liabilities, and equities. You’ll need both reports to get the full picture.
Profit & Loss: Revenue – Expenses = Net Profit
The first report is the P&L, or the income statement if you’d like to call it that. You probably already look at this report frequently to see what your total sales were for the month and how much you spent in office supplies. The profit and loss report includes the total amounts recorded in your income and expense accounts.
At the end of the year, our total expenses are subtracted from our total income to calculate our profit for the year. All business owners are familiar with the profit and loss equation because it seems to give you a clear picture of where the money is coming from and where it’s being spent. But the profit and loss alone doesn’t show you everything… and here’s why.
Balance Sheet: Assets = Liabilities + Equity
The other report that small businesses need to understand is the balance sheet. It includes a summary of our total assets, liabilities, and equity. Many small business owners know that the balance sheet is important, but they don’t really understand what it’s telling them.
While the purpose of the P&L is to show how your business performed over a specific time period, the purpose of the balance sheet is to show the financial position of your business on any given day. The balance sheet can tell you how much money your business has in the bank and how likely it is that your 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.
→TL;DR: You won’t be able to get this done without your business’s P&L and balance sheet!
What Are Assets, Liabilities, and Equities, Exactly?
Go grab that balance sheet—we’re going to use it first. But… before we can use the balance sheet for analysis, we need to really understand the three types of accounts included on it! Those are assets, liabilities, and equity. Here goes.
Assets: What You Have
An asset is something that the business owns—in other words, what a business has
Some common asset accounts include cash or bank accounts, accounts receivable (monies owed to you by your customers), inventory, fixed assets (buildings, machinery, or furniture), investments
Intangible assets like patents, trademarks, or non-compete covenants count, too
Asset accounts are classified as either short-term (meaning they will be used up or paid within one year) or long-term (meaning it will take more than 12 months to use them or pay them back).
Liabilities: What You Owe
A liability is something that you owe, whether to an individual, business, or institution (like a bank or the IRS)
Liabilities are accounts payable (monies owed to your vendors), a car loan, or mortgage on a building
Amounts owed to customers for gift certificates or prepaid services are also examples of liabilities
Liability accounts are classified just like asset accounts—either short- or long-term.
Equity: What You Really Have
Equity can be looked at as the net worth of the business
If we rewrite the equation for the balance sheet another way, it actually makes much more sense: Assets – Liabilities = Equity
Equity accounts take the form of contributions (money invested into the company), distributions (money taken out of the company by the owners), and retained earnings (the cumulative profit or loss of the business since its inception). At the end of each fiscal year, the net profit (or loss) from the profit and loss is added to (or subtracted from) retained earnings and the amounts in the income and expense accounts reset to zero.
Equity accounts can have many different names depending on the organizational structure of a business. For example, a sole proprietor’s equity accounts are usually called Owner’s Equity for money put into the business and Owner’s Draw for money given back to the owner. And a corporation has a Common Stock account (the initial investment into the company), Additional Paid in Capital (APIC, or additional amounts invested by the shareholders), and Shareholder’s Distributions or Dividends Paid (amounts taken out of the company by the shareholders as a return of their investment or share of the company’s profits).
→TL;DR: A simple way to think about assets are what you have (like cash and trademarks); liabilities are what you owe (like accounts payable and outstanding loans); and equity as your business’s net worth. Or, your assets minus your liabilities is the value of your equity.
How to Gauge the Financial Health of Your Business
That equation you learned above: Assets – Liabilities = Equity? That’s called “the balance sheet equation.” And once it clicks for you, you can use it, along with that profit and loss statement, to get important information about the health of a company.
There’s a little more math involved, true, but in the end, you’ll come out with some really important numbers to help you out. Some important ratios you can use to gauge the health of your business are:
Current ratio (total current assets ÷ total current liabilities): Measures the ability of a company to pay short- and long-term debts
What you can answer: Is my company capable of paying all its bills in the short term?
Working capital (total current assets – total current liabilities): Represents the amount of capital a business has to operate the business
What you can answer: How much does my company have to invest in the business after meeting all its obligations?
Inventory turnover (average inventory ÷ cost of goods sold): Measures the number of times inventory is sold and replaced within a certain period
What you can answer: Am I being efficient with my inventory and stocking the right products?
Return on equity: (net income ÷ equity): Shows how much profit a company generates per dollar of equity.
What you can answer: Is your business giving you a return on your investment?
Many of the financial ratios that lenders use when determining credit risk are based on balance sheet accounts, so understanding how they relate to your situation can really help you before you start to look for a business loan.
→TL;DR: Once you have a handle on “the balance sheet equation,” you can learn a ton more about your business with important ratios. (They’re listed above!)
Using Assets, Liabilities, and Equity to Get a Picture of Your Business Financial Health
When you look at the profit and loss and balance sheet together, you get the full financial picture of your business. And although a company may show a profit on the profit and loss statement, the balance sheet might tell a different story. That’s why you’ll want to get into the habit of reviewing both reports frequently, and you’ll have a great handle on how your business is doing.
What Does Net Worth Mean?
In a nutshell, your net worth is really everything you own of significance (your assets) minus what you owe in debts (your liabilities). Assets include cash and investments, your home and other real estate, cars or anything else of value you own. Liabilities are what you owe on those assets — including car loans, your mortgage, and student loan debt.
Net worth is a measure of your financial health because it basically says what you would have left over if you sold all of your assets to pay all of your debts. Every financial move you make should be aimed at increasing your net worth. This means either increasing assets, or decreasing liabilities.
(For a deeper look at net worth, check out What Does Your Net Worth Really Mean.)
How to Calculate Net Worth
Calculating your net worth really isn’t all that hard. It just takes a bit of time, some scratch paper, and a calculator.
Step 1: Make a list of all of your assets and their estimated value.
This includes retirement savings, your current checking and savings account balances, any bonds you might have, the total value of any stock holdings you might have, your home, and your automobiles. I usually don’t include any physical assets less valuable than my car, but you can do this if you wish.
While some of these assets will have very specific and obvious values (such as your bank statement), others will require you to make an estimate. Sites like Zillow or Redfin offer estimated home values, and while they shouldn’t be taken too literally, they can give you a ballpark idea of what your home is worth. Kelley Blue Book or Edmunds can help you determine the value of your car, and looking up comparable items on a resale site like eBay can help you gauge the real value of other random items.
I usually make a list that says ASSETS in big letters at the top. Underneath that, on the left, I list what the asset is and on the far right, I list the value of that asset so that the decimal points of all of the assets line up. This makes the calculation of your total value much easier.
Once you’ve listed every asset you can think of, write TOTAL in big letters over on the left, then add up the numbers. Once you have this total, you’ve got the total value of your assets.
Step 2: Make a list of all of your debts.
Now, list all of your credit card balances, personal loans, student loans, auto loans, home loans, and so forth. Much like with the assets list, I recommend a big header that says DEBTS, with each debt listed below that on the left side and the amount of the debt over on the right, with the decimals lined up for easy figuring. (Of course, you can also use a spreadsheet.)
Once you’ve listed all of your debts, write TOTAL in big letters on the left, then add up all of the debt numbers. This is the total amount of all of your debts.
Step 3: Subtract.
Finally, just subtract your total debt from your total assets. The resulting number is your net worth.
How to Calculate Net Worth: Two Examples
To illustrate the process, let’s look at two examples.
Example 1: Gina
Gina is 35 years old. She owns a home worth $250,000, and still owes $150,000 on the mortgage. Her six-year-old car is now only worth about $7,000, but it’s all paid off. She has $1,000 in credit card balances, $25,000 in her 401(k), about $5,000 in her savings account, and $20,000 remaining on her student loans.
Total assets: $287,000
Credit cards: $1,000
Student loans: $20,000
Total debts: $171,000
GINA’S NET WORTH: $287,000 – $171,000 = $116,000
Example 2: Emma
Emma, meanwhile, is 25 years old and rents an apartment. She has a newer car worth $20,000, but still owes $15,000 on it. Relatively new in her job, she only has $2,000 in her 401(k), and $1,000 in savings; she’s paying down $50,000 in student loans. And she’s racked up $5,000 in credit card debt as well.
Total assets: $23,000
Credit cards: $5,000
Auto loan: $15,000
Student loans: $50,000
Total debts: $70,000
EMMA’S NET WORTH: $23,000 – $70,000 = (-$47,000)
Some Implications of Net Worth in Practice
What does a negative net worth mean?
Some people panic when they calculate their net worth and discover that it’s negative. This is usually the result of a young earner with a substantial amount of student loan debt and also a loan on a rapidly depreciating automobile. Why is your net worth negative? You simply haven’t earned or invested enough money yet to overcome the weight of the debt. Don’t worry, it will come.
However it can also be due to overborrowing — for instance, if you’ve racked up huge credit card bills, and are not paying them down. This creates a large number in the liabilities column, with no valuable asset to offset it.
How can I make my net worth bigger?
Every time you make one of those debts smaller or one of those assets grows more valuable, your net worth will increase. So, you can increase your net worth by paying off your debts, saving and investing money, and reducing your spending. If you own a home, paying down your mortgage while property values rise can increase your net worth from both sides of the ledger.
On the other hand, your net worth goes down when you take on additional debt with little or nothing to show for it – particularly when you spend money on “small” things, such as clothes, food, and even interest on loans. Whenever you buy something frivolous, your net worth goes down.
Related: Here’s How Much the Average American Pays in Interest Each Year
How Often Should I Calculate My Net Worth?
I find it useful to calculate my net worth every month. My goal each month is to increase my net worth over the previous month — which means my expenses for the month were less than my income. I use the excess to pay down debts or increase personal savings.
Now that you know about net worth, how to calculate it, and how it changes, you could use a site like Mint.com to automatically calculate your net worth in real time and keep track of all of your finances. If you’re worried about online security, then simply stick to the longhand calculation ever month!