Sunday, May 8, 2011
Another Approach to Balance Sheets
Why in the world does Assets = Liabilities + Equity? This equation has tormented many new business owners since the dawn of double entry bookkeeping. But understanding Balance Sheets is crucial for understanding your business’ financial health.
Assets are anything of value in your company. Things like cash, inventory, office equipment, prepaid expenses… these are all worth something to you and thus, would be considered an asset.
Equity is what you, or any other investors in your company, own. So, if you invest $1,000 into your business, you have $1,000 in equity. This must go on your balance sheet. Likewise, any money you make from your business belongs to you, the owner, and so that would also go on your balance sheet under equity as “Retained Earnings.”
Liabilities are stuff you owe other people. If you get a loan from a bank or from a friend, that is a liability because you are obligated to pay them back.
So let’s look at a simple example to show how Assets=Liabilities + Equity
(Adapted from http://www.theequator.com/fin/balance.htm).
If you had a pie, and you are the only owner and you don’t owe anybody anything then you can eat the whole pie. If you own a pie and you owe Frank one slice, then you probably shouldn’t eat the whole thing since then Frank would never get his slice. But, if you take that pie and give Frank back his slice that he is owed (liabilities) and you keep the rest (equity) then the entire pie is accounted for. The pie (assets) must equal Frank’s piece (liabilities) and everything else (equity).
Make sense? Let’s do another example:
Assets = Liabilities + Equity may look like a bunch of accounting mumbo jumbo but you are probably using this concept in your everyday life and not even know it. If you own a home and are paying a mortgage, you probably are thinking in terms of “Assets=Liabilities + Equity.” Let’s take a closer look:
Let’s say you buy a house for $500,000. If you pay for the whole house with your own money, meaning you own it free and clear, then you have 100% ownership (equity). But maybe you don’t have $500,000 sitting around and you need to get a loan from the bank for $250,000 or 50% of the house. Well, now your house (asset) is made up of the $250,000 you owe the bank (liabilities) and the $250,000 you invested in the house (equity).
House (Asset) = $500,000
Bank Loan (Liability) = $250,000
Your Investment (Equity) = $250,000
So Assets = Liabilities + Equity
Let’s go one step further. After 5 years of owning your home, the value goes up to $750,000 (pretty unlikely in our current real estate market, I know, but just pretend in your Fantasyland). How do you account for that extra $250,000? Well, it belongs to you, not the bank so we would put that under equity (what you own).
House (Asset) = $750,000
Bank Loan (Liability) = $250,000
Owner’s Investment + Earnings (Equity) = $500,000
So, you see here we’ve done a very simple example of double entry bookkeeping. We added $250,000 to the assets and $250,000 to the equity so that everything balances out.
In the recent real estate downturn, many people’s homes were worth less than what they owed to their bank and this put them in big financial trouble. The same is true for your business. You never want to get in a position when what you owe people (liabilities) is more than what you have (assets). The balance sheet will tell you just that. See why it’s important?
So remember, the goal here is to make sure that what you have (assets) covers what you owe people (liabilities), and everything left over belongs to you (equity). So Assets = Liabilities + Equity.