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5 Basic Accounting Equation, An Easy Explanation!

Tayang 30 Sep 2022
Last updated 05 January 2024

What is the accounting equation, and how does it work? Let’s take a closer look to some of the accounting fundamentals that is important for your business.

Accounting is an essential part of running a business, however, this does not imply that you must be an accountant to grasp the fundamentals.

Looking at how you pay for your assets—debt-financed or capital-financed—is one of the fundamentals. To see the difference, use the accounting equation.

The Accounting Equation: What Is It and How Does It Work?

The accounting equation is used in double-entry accounting to show the relationship between assets, liabilities, and equity.

Using the accounting also known as the balance sheet equation, you can determine if you are financing your assets with business funds or debt.

You don’t utilize the balance sheet equation if your company implements single-entry accounting.

The accounting equation, on the other hand, depicts a balance between the two sides of your general ledger.

In single-entry accounting, there is no need for a balance on both sides of the general ledger, it means that you monitor your assets and liabilities separately.

What is the Significance of the Accounting Equation?

The accounting equation is crucial since it may provide you with a comprehensive view of your company’s financial position.

It is the basis for double-entry accounting and is the norm for financial reporting.

You can’t read your balance sheet or understand your financial statements without knowing the balance sheet equation.

Your accounting equation can assist you in answering issues such as:

  • Do you have enough cash on hand to invest in new equipment or office space?
  • Should you take out a business loan to make acquisitions for your company (increasing both obligations and assets)?
  • Do you have sufficient earnings (assets) to pay off your debts?

Some Basics of the Accounting Equation

Here are some basic accounting formulas to know if you own a small firm or even the latter category.

These formulas are considered universal to any organization and will supply you with the data you need to determine your company’s viability and health.

1. Basic Accounting Equation

You must first understand the sections of the balance sheet that are employed in the accounting equation before you can use it.

A balance sheet is a financial document that shows how much money your organization has.

The balance sheet is divided into three sections which are assets, liabilities, and equity.

Assets = Liability + Owner’s Equity

  • Assets are everything your firm owns that will benefit you in the future, such as property, cash, inventory, and equipment.
  • Liabilities are financial commitments that must be met, such as lease payments, merchant account fees, and debt service.
  • Owner’s equity are the percentage of the company that belongs to the owner.

Example:

Imagine a small business named “Green Gardens”. Here’s a simplified version of its balance sheet:

Assets:

  • Cash: $10,000
  • Inventory (plants, seeds, etc.): $5,000
  • Equipment (gardening tools, machinery): $15,000
  • Property (land and building): $70,000 Total Assets = $10,000 + $5,000 + $15,000 + $70,000 = $100,000

Liabilities:

  • Lease Payments (for some gardening equipment): $20,000
  • Merchant Account Fees (fees for payment processing): $5,000
  • Debt Service (loan for the property): $40,000 Total Liabilities = $20,000 + $5,000 + $40,000 = $65,000

Owner’s Equity: This can be calculated using the Basic Accounting Equation: Assets ($100,000) = Liabilities ($65,000) + Owner’s Equity Owner’s Equity = Assets – Liabilities Owner’s Equity = $100,000 – $65,000 = $35,000

So, for “Green Gardens”:

  • Total Assets are $100,000
  • Total Liabilities are $65,000
  • Owner’s Equity is $35,000

This means that after accounting for all liabilities, the owner of “Green Gardens” has an equity or ownership value of $35,000 in the business.

2. Net Income

You may compute your net income by subtracting your revenue from your expenses. At the end of the day, this is the amount of money you have earned.

When your business is in its early stages, this number may be negative, thus the goal is for your net income to become positive, indicating that your company is profitable.

Net Income = Revenues – Expenses

  • Revenues refers to the sales and other positive cash inflows into your business.
  • Expenses refers to the costs of making or generating the revenue.

Example:

Imagine a small bakery named “Sweet Delights”. Here’s a simplified breakdown of its monthly financials:

Revenues:

  • Sales of cakes: $8,000
  • Sales of pastries: $4,000
  • Catering services: $3,000 Total Revenues = $8,000 + $4,000 + $3,000 = $15,000

Expenses:

  • Rent for the bakery space: $2,500
  • Salaries for employees: $5,000
  • Ingredients and baking supplies: $3,000
  • Utilities (electricity, water, etc.): $500
  • Marketing and advertising: $1,000 Total Expenses = $2,500 + $5,000 + $3,000 + $500 + $1,000 = $12,000

Net Income: Using the formula: Net Income = Revenues ($15,000) – Expenses ($12,000) Net Income = $3,000

So, for “Sweet Delights”:

  • Total Revenues are $15,000
  • Total Expenses are $12,000
  • Net Income is $3,000

This means that after accounting for all expenses, “Sweet Delights” has earned a profit or net income of $3,000 for the month. This indicates that the bakery is currently profitable.

3. Break-Even Point

The next accounting equation that is very important is Break-Even Point. You can find your break-even point by dividing your fixed costs by the sale price of your goods, minus the amount it costs to create your product.

This will tell you how much you need to sell to cover all of your expenditures.

Break-Even Point = Fixed Costs / Sales Price – Variable Cost Per Unit

  • Fixed costs are costs that you must pay on a regular basis in order to conduct business. These expenses include things like insurance fees, rent, and employee compensation, among others.
  • Sales price is the retail price at which you sell your products or services.
  • The variable cost per unit is the cost of producing your product.

Example:

Imagine a company named “EcoBottles” that produces reusable water bottles. Here’s a simplified breakdown of its financials:

Fixed Costs:

  • Rent for the factory: $10,000 per month
  • Salaries for permanent staff: $15,000 per month
  • Insurance fees: $1,000 per month Total Fixed Costs = $10,000 + $15,000 + $1,000 = $26,000 per month

Sales Price: Each bottle is sold for $20.

Variable Cost Per Unit:

  • Cost of materials for each bottle: $5
  • Labor cost for producing each bottle: $3 Total Variable Cost Per Unit = $5 + $3 = $8

Break-Even Point: Using the formula: Break-Even Point = Fixed Costs / (Sales Price – Variable Cost Per Unit) Break-Even Point = $26,000 / ($20 – $8) Break-Even Point = $26,000 / $12 Break-Even Point = 2,166.67

So, for “EcoBottles”:

  • They need to sell approximately 2,167 bottles in a month to cover all of their expenditures and break even.

This means that if “EcoBottles” sells any number of bottles above 2,167 in a month, they will start making a profit. If they sell less, they will incur a loss.

4. Cash Ratio

This accounting ratio will give you an indication of how much money you have on hand right now.

This figure of accounting equation depicts how successfully your company can pay off its present debts. The higher the number, the healthier your firm is in this situation.

Cash Ratio = Cash / Current Liabilities

  • Cash refers to the quantity of money you have on hand. This can include both real money and money equivalents (i.e. highly liquid investment securities).
  • Current liabilities refers to the company’s current indebtedness.

Example:

Imagine a tech startup named “TechNova”. Here’s a basic breakdown of its financials:

Cash:

  • Money in the bank: $50,000
  • Money market funds (highly liquid investment securities): $20,000 Total Cash = $50,000 + $20,000 = $70,000

Current Liabilities:

  • Short-term loan to be paid within a year: $40,000
  • Accounts payable (money owed to suppliers): $10,000 Total Current Liabilities = $40,000 + $10,000 = $50,000

Cash Ratio: Using the formula: Cash Ratio = Cash / Current Liabilities Cash Ratio = $70,000 / $50,000 Cash Ratio = 1.4

So, for “TechNova”:

  • The Cash Ratio is 1.4.

This means that for every dollar of liability “TechNova” has, they have $1.4 in cash or cash equivalents. A Cash Ratio greater than 1 indicates that the company can pay off its current debts using only its cash or cash equivalents, which is a sign of strong short-term financial health.

5. Debt-to-Equity Ratio

A high debt-to-equity ratio indicates that a large amount of your company’s funding is provided by outside sources, such as banks.

If you’re trying to get more money or find investors, having a high debt-to-equity ratio can make it more difficult to get funding.

Debt-to-Equity Ratio = Total Liabilities / Total Equity

  • Total liabilities are all of the charges you owe to other people, such as loan or interest payments.
  • Total equity refers to the amount of the company that belongs to the owner or other employees. To put it another way, it’s the amount of money the owner has put into his or her own business.

Example:

Imagine a fashion boutique named “Elegance Couture”. Here’s a basic breakdown of its financials:

Total Liabilities:

  • Bank loan: $100,000
  • Interest payable: $5,000
  • Accounts payable (money owed to suppliers): $20,000 Total Liabilities = $100,000 + $5,000 + $20,000 = $125,000

Total Equity:

  • Owner’s capital (money invested by the owner): $70,000
  • Retained earnings (profits that have been reinvested): $30,000 Total Equity = $70,000 + $30,000 = $100,000

Debt-to-Equity Ratio: Using the formula: Debt-to-Equity Ratio = Total Liabilities / Total Equity Debt-to-Equity Ratio = $125,000 / $100,000 Debt-to-Equity Ratio = 1.25

So, for “Elegance Couture”:

  • The Debt-to-Equity Ratio is 1.25.

This means that for every dollar of equity in the business, “Elegance Couture” has $1.25 in debt. A ratio greater than 1 indicates that a significant portion of the company’s financing comes from debt. This can be a concern for potential investors or lenders, as it might indicate higher financial risk.

Simplify Accounting Process by Using Software Such as Mekari Jurnal

Those are only some basic accounting equations that you need to know. There are more equations that are not mentioned yet.

Accounting is not easy, therefore you can use an online accounting software such as Mekari Jurnal to simplify the process.

Mekari Jurnal features precise profit and loss estimations in their data.

Mekari Jurnal accounting application and system reduces the possibility of errors in everyday accounting work by providing an easy-to-use solution.

Mekari Jurnal accounting and asset management software is rich in feature, simple to automate, and it’s available online (cloud or web-based), allowing for real-time access to the accounting process.

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