Accounting Equation
Candlefocus EditorTo expand on this, the accounting equation states that a company’s assets (what it owns) are equal to the total of its liabilities (what it owes) and shareholders' equity (the difference between the amount that shareholders have invested in the company and the amount of their claims on the company's assets):
Assets = Liabilities + Shareholders’ Equity
This foundation of the double-entry accounting system serves as a cornerstone of key financial reports such as the balance sheet, income statement and statement of cash-flows.
Assets are theoretically exchanged between creditors and shareholders. When liabilities and shareholders' equity increase, so must assets. Similarly, when liabilities and shareholders’ equity decrease, so must assets. In this way, the accounting equation shows how changes to liabilities and shareholders' equity are matched by an equivalent change in the company's assets. For example, when the company pays off a lender, the asset of cash will decrease by the amount paid and the liability of notes payable will be reduced by the same amount.
The accounting equation also helps to measure a company's financial health. For firms that are entirely financed with debt, their equity (assets minus liabilities) will be zero or negative. Companies that have significant amounts of shareholders' equity have a stronger balance sheet and may be in stronger financial health than those with a negative or zero equity.
The accounting equation is a fundamental part of financial analysis and should be included in any business decision-making. It is important for stakeholders, such as shareholders and creditors, to understand the accounting equation and the implications of financial transactions. Through the accounting equation, managers, business owners and other stakeholders gain a better understanding of their financial situation and can make decisions accordingly.