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.
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.
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.
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.
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.
Simplify Accounting Process by Using Software Such as Jurnal by Mekari
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 Jurnal by Mekari to simplify the process.
Jurnal features precise profit and loss estimations in their data. Jurnal accounting application and system reduces the possibility of errors in everyday accounting work by providing an easy-to-use solution.
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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