The accounting equation can have many forms and uses in Bookkeeping, but you should not ignore any accounting equation if you want to lead your business to success with. So, what is the accounting equation? The accounting equation is the foundation of your company’s balance sheet, which includes your assets, liabilities, and the owner’s equity, and other financial statements. To help you understand the significance of the accounting equation, we prepared you a short overview of the accounting equations that will give you valuable figures.
The Accounting Equation: Role in Business
What is the practical use of the accounting equation, and why is it given so much importance? It provides the basis for calculating many financial ratios (liquidity, return on investment, profitability, etc.). It also makes it possible to prepare financial statements and evaluate the operations of the enterprise and its effectiveness in the development of new products/services.
Every accounting equation reviewed below is essential for the manager, investors, and owner. With the help of the accounting equation, it will be easier to evaluate your business operations and make the right decisions. Although they seem relatively simple when you have multiple accounts to track and include in the calculation help from professional accountants might be necessary.
The Accounting Equation – A Basic Equation
The accounting equation in the illustration above (Assets = Liabilities +Stockholders’/Owner’s Equity) represents an equation based on which a balance sheet and other financial statements are formed. It helps owners, managers, and investors to effectively evaluate the company operations and make informed decisions. This ratio should remain valid for any point in time, including being correct for the forecast period when predicting the financial state of a business in the future or after certain transactions.
As you can see, the accounting equation consists of assets, liabilities, and owner’s or shareholders’ equity. The assets portion represents how much the company owns, while the liabilities and stockholders’/owner’s equity tell where these assets came from. Liabilities mean that the funds came from the outside source while the owners or stockholders’ equity portion came from the money that the owners invested in the company.
The calculation of the amount of the company’s net income is made using the accounting equation: Net Income = Revenues – Expenses. In other words, it is the difference between the following two items:
- Revenue – the income from sales or additional positive cash inflow, such as service fees and commissions.
- Expenses – the number of costs related to business operations, depreciation, interest, taxes, and other expenses.
Net profit is the profit of the company before the payment of dividends. This figure can be found in the company’s income statement. It is an essential indicator of how profitable a company is over a specified period. If the expenses are more significant than revenues, this can be net loss instead of net profit. This indicator is also used to calculate earnings per share.
Profitability is the primary indicator of the success of any company. The higher it is, the more attractive the business is for the owner and investors. Three ratios help to evaluate it:
⮚ The accounting equation for profit margin looks like this: Profit Margin = NetIncome ÷ Sales. The value for five or even ten years can show a trend in the company’s profitability.⮚ The accounting equation for return on assets (ROA), also known as return on investment (ROI), is considered as the ratio of profit (net income) to the average value of the assets – Return on Assets = Net Income / Total Assets. The accounting equation result will show how well a company utilizes its assets and controls the costs.⮚ The return on equity (ROE), also known as return on investment (ROI), is calculated using this formula: Return on Equity = Net Profit / AverageStockholders’ Equity. Unlike the ROA ratio above, ROE shows return the return specifically on investors’ funds without including all the other assets.
Retained Earnings Equation
The goal of each enterprise is to make a profit. In most cases, profit does not only go to the owners of the company. Part of it goes into the development of the company and its other needs or a reserve. Note that in addition to profit, the activities of the organization can lead to a loss. Owners are also liable for such obligations.
The accounting equation for calculating what is left after owners take their part from profits (dividends) is as follows: Retained Earnings = Beginning Retained Earnings +Net Income or Net Loss – Cash Dividends. Retained earnings reflect the earnings after payment of dividends for the whole period of the company’s existence. If the company just started operating or spent all the funds in this account, it might have a $0 for the beginning retained earnings.
The Break-even point is a sales volume at which the company covers all its costs without making a profit. Its value plays a vital role in the matter of sustainability and solvency of the company. If the break-even point is exceeded, the company makes a profit; if the break-even point is not reached, the company incurs losses.
The break-even point is calculated for the company as a whole or some goods or services. It shows the effectiveness of a commercial project since the investor needs to know when the project will finally pay off, what is the level of risk for investors. To calculate the break-even point, it is necessary to use the following formula: Break-EvenPoint = (Sales – Fixed Costs – Variable Costs = $0 Profit).
The debt to equity ratio, calculated as Debt-to-Equity Ratio = Total Liabilities ÷ TotalEquity, describes the financial stability of the company and shows how much borrowed funds came from issuing stock to shareholders as opposed to loans and other debts. This ratio reflects the structure of capital and gives a general description of the financial condition.
Both the numerator and the denominator are taken from the organization’s balance sheet. Liabilities include both long-term and short-term liabilities. This ratio also shows the extent to which shareholders’ equity can fulfill a company’s obligations to creditors in the event of a liquidation.
Cost of Goods Sold
The accounting equation we want to also include in this article is the cost of goods sold(COGS), which is included in one of the financial statements – the income statement. The price of products sold represents the total amount of the company’s direct costs at all stages of the production process and other costs at the time of sale. It is calculated using the following formula: Cost of Goods Sold = Beginning Inventory + Cost of purchasing New Inventory – Ending Inventory.
The dynamics of the cost for specific periods, as well as the assessment of its value after each sale of products, allows summarizing the feasibility and rationality of the acquisition and use of material and labor resources. Also, the calculated cost indicators in different periods help to develop marketing and economical methods to reduce their share in profits.