Introduction of Balance Sheet Equation
The fundamental part of accounting and the most basic equation in accounting is the Balance Sheet Equation. It forms the base for a double-entry accounting system.
The Balance Sheet shows the company’s total assets and how these assets are financed, i.e. through debt or equity. The balance sheet shows stake owners of the business, and that is how we come up with the balance sheet equation as:
Example of Balance Sheet Equation
Following is the Balance Sheet of ABC Ltd for the period 2020 and 2021.
It shows how either debt or equity finances every asset, and that is how the balance sheet equation is formed.
| Consolidated Balance Sheet of ABC Ltd as of 31 Dec 2021 | ||
| In Mn | In Mn | |
| Asset | 2020 | 2021 |
| Property, Plant, Equipment | $1,000 | $1,100 |
| Goodwill | $200 | $215 |
| Other Assets | $400 | $450 |
| A) Total | $1,600 | $1,765 |
| Current Assets | ||
| Cash and Cash Equivalents | $700 | $775 |
| Inventories | $350 | $390 |
| Account Receivables | $235 | $250 |
| B) Total Current Asset | $1,285 | $1,415 |
| Total Assets A+B | $2,885 | $3,180 |
| Liabilities | ||
| Shareholders Equity | ||
| Common Stock | $500 | $500 |
| Retained Earnings | $605 | $680 |
| A) Total Shareholder’s Equity | $1,105 | $1,180 |
| Long Term Debt | $500 | $570 |
| Other Long term liabilities | $580 | $650 |
| B) Total | $1,080 | $1,220 |
| Current Liabilities | ||
| Accounts Payable | $500 | $540 |
| Accrued Expenses | $200 | $240 |
| C) Total Current Liabilities | $700 | $780 |
| Total Liabilities And Shareholders Equity (A+B+C) | $2,885 | $3,180 |
The Balance Sheet Equation is the base of a double-entry accounting system. As per this rule, every transaction will result in two entries in the books. Hence, the Accounting equation will always be balanced on both sides.
Components of the Balance Sheet Equation
Balance sheet components show how the balance sheet is structured, and three major components are Assets, Liabilities, and Shareholders’ Equity. They are further divided by:
1. Assets
- Current Assets: Assets, which are expected to be converted into cash generally within a year.
- Cash and Equivalents: A most liquid asset in the balance sheet, while assets with short term, i.e. under three months maturity, are also considered under cash equivalents. Cash equivalents can be liquidated easily if needed.
- Account Receivable: Revenue which is still on credit. As the company recovers account receivable, this amount decreases while the company will get the same amount of cash.
- Inventory: Amount of raw materials, Work in Progress, and finished goods that have not been sold.
- Non-Current Assets:
- Property, Plant, and Equipment: These are generally long-term assets. Most of these items are generally recorded after the deduction of depreciation.
- Intangible assets: In this section, the company includes assets that may not be identifiable. It includes Patents, Licences, Goodwill, etc.
2. Liabilities
- Current Liabilities: Liabilities, which has to be paid and settled within a year by the company.
- Accounts payable: Amount of money the company owes to suppliers or services bought on credit. As the company pays off its account payable this amount, gets reduced with the same reduction in cash.
- Accrued expenses: Bills, which are, still need to be paid by the company. These items include general expenses like distribution expenses etc.
- Non-Current Liabilities:
- Long-term debt: Long-term debt is generally the company’s projects, which are financed for a long period, or assets bought by the company for a long-term purposes, which are financed by loans, Bond issues, Capital leases, etc.
Importance of Balance Sheet Equation
The importance of the balance sheet equation is:
- Foundation of Accounting: Balance sheet equation set base for a double-entry accounting system, which considers every transaction in the company will have two entries in books of accounts.
- Assets = Liabilities + Equity Logic: The logic of the Balance sheet equation is every asset in the company is financed by liability, i.e. Debt (Short or long-term), or by equity, i.e. by owners capital invested in the company. Mismatch on both sides helps accountants and finance professionals point out quick mistakes made in building books of accounts.
- Represents Stake owners interests in business: Balance sheet equation shows:
- Assets: Which are owned and controlled by the company.
- Liabilities: Obligation, which companies have to pay off.
- Equity: Owners’ investments in the business.
- Shows the company’s liquidity, leverage, Financial capacity, growth:
- Liquidity: The balance sheet reflects how the company can pay its short-term obligations.
- Leverage: How much the company’s activities are financed by debt and whether the company can pay off this debt or not.
- Financial Capacity: The balance sheet shows the financial capacity of the firm and how assets are financed, the ability to pay off its debts, the efficiency of turning assets into revenue and cash management.
- Growth: Overall view of the balance sheet shows how the company is performing over a period. Ability to generate returns through various assets, which are financed by equity and debt.
- Universal application: The balance sheet equation is applicable everywhere, which makes regulators, companies, and the public to understand the financial statements of any company.
Advantages
Some of the advantages are given below:
- Risk and returns: The balance sheet shows the assets and liabilities of the company. It shows the ability of the company to pay out its short-term liability as well as the ability to settle long term debt. At the same time, it also shows whether the company can generate returns compare to the risks (debt) and overall growth structure of the company over a period.
- Helpful to secure loans and additional investments: Due to the balance sheet equation, reading and understanding of balance sheet become easy and useful for lenders and new investors. It helps them to understand the company’s financial ability to payout its debt and grow in the future, which further help them to decide to invest in a company or not.
- Ratio calculations: The balance sheet equation is the base part of the double-entry accounting system. It helps us to understand various ratios. E.g. the current ratio provides liquidity status, the debt to equity ratio provides leverage status, etc. For investors as well as businesses, these ratios are important as they reflect how well the current structure and operations of the company are well managed.
Disadvantages
Some of the disadvantages are given below:
- Misstated long-term assets: The balance sheet records the value of long-term assets at historical prices instead of current value. Book value can create a distortive picture of the company’s financials, as it underestimates long-term assets.
- Need comparison: To understand the balance sheet as per the balance sheet equation and making investments or business decision needs comparison of the balance sheet of peers over many years.
Key Points
- The balance sheet equation or accounting equation is the base for the double-entry accounting system.
- Asset = Liabilities + Equity ( Logic every asset is financed by debt or equity)
- The universal equation helps financial professionals, business owners, and investors understand, compare, and make investment decisions.
- Financial capacity: Financial equation helps us to understand the company’s financial structure and ability to pay off its debt and grow over the years.
Conclusion
The balance sheet equation is a very basic and simple equation, which helps us understand the logic behind financial statements. Mismatch on the asset or liabilities side helps point out mistakes in calculations or missing entry of transactions for finance professionals and accountants. The universal application makes it easy for business owners and investors to make important decisions.
Recommended Articles
This is a guide to the Balance Sheet Equation. Here we also discuss the introduction and components of the balance sheet equation along with advantages and disadvantages. You may also have a look at the following articles to learn more –
