The accounting equation can have many forms and uses, but you should not ignore anyaccounting equation if you want to lead your business to success. The accountingequation is the foundation of your company's balance sheet, which includes yourassets, liabilities, and the owner’s equity, and other financial statements. To help youunderstand the significance of the accounting equation, we prepared you a shortoverview 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 muchimportance? It provides the basis for calculating many financial ratios (liquidity, returnon investment, profitability, etc.). It also makes it possible to prepare financialstatements and evaluate the operations of the enterprise and its effectiveness in thedevelopment of new products/services.
Every accounting equation reviewed below is essential for the manager, investors, andowner. With the help of the accounting equation, it will be easier to evaluate yourbusiness operations and make the right decisions. Although they seem relatively simple,when you have multiple accounts to track and include in the calculation help fromprofessional 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 sheetand other financial statements are formed. It helps owners, managers, and investors toeffectively evaluate the company operations and make informed decisions. This ratioshould remain valid for any point in time, including being correct for the forecast periodwhen predicting the financial state of a business in the future or after certaintransactions.
As you can see, the accounting equation consists of assets, liabilities, and owner’s orshareholders’ 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 orstockholders’ equity portion came from the money that the owners invested in thecompany.
The calculation of the amount of the company’s net income is made using theaccounting equation: Net Income = Revenues – Expenses. In other words, it is thedifference between the following two items:
- Revenue – the income from sales or additional positive cash inflow, such asservice 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 canbe found in the company's income statement. It is an essential indicator of howprofitable a company is over a specified period. If the expenses are more significantthan revenues, this can be net loss instead of net profit. This indicator is also used tocalculate earnings per share.
Profitability is the primary indicator of the success of any company. The higher it is, themore attractive the business is for the owner and investors. Three ratios help toevaluate 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 thecompany’s profitability.⮚ The accounting equation for return on assets (ROA), also known as return oninvestment (ROI), is considered as the ratio of profit (net income) to the averagevalue of the assets – Return on Assets = Net Income / Total Assets. Theaccounting equation result will show how well a company utilizes its assets andcontrols the costs.⮚ The return on equity (ROE), also known as return on investment (ROI), iscalculated using this formula: Return on Equity = Net Profit / AverageStockholders' Equity. Unlike the ROA ratio above, ROE shows return the returnspecifically 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 tothe owners of the company. Part of it goes into the development of the company and itsother needs or a reserve. Note that in addition to profit, the activities of the organizationcan lead to a loss. Owners are also liable for such obligations.
The accounting equation for calculating what is left after owners take their part fromprofits (dividends) is as follows: Retained Earnings = Beginning Retained Earnings +Net Income or Net Loss – Cash Dividends. Retained earnings reflect the earnings afterpayment of dividends for the whole period of the company’s existence. If the companyjust started operating or spent all the funds in this account, it might have a $0 for thebeginning retained earnings.
Break-even point is a sales volume at which the company covers all its costs withoutmaking a profit. Its value plays a vital role in the matter of sustainability and solvency ofthe company. If the break-even point is exceeded, the company makes a profit; if thebreak-even point is not reached, the company incurs losses.
The break-even point is calculated for the company as a whole or some goods orservices. It shows the effectiveness of a commercial project since the investor needs toknow when the project will finally pay off, what is the level of risk for investors. Tocalculate 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 borrowedfunds 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 financialcondition.
Both the numerator and the denominator are taken from the organization’s balancesheet. Liabilities include both long-term and short-term liabilities. This ratio also showsthe 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 atall stages of the production process and other costs at the time of sale. It is calculatedusing the following formula: Cost of Goods Sold = Beginning Inventory + Cost ofPurchasing New Inventory – Ending Inventory.
The dynamics of the cost for specific periods, as well as the assessment of its valueafter each sale of products, allows summarizing the feasibility and rationality of theacquisition and use of material and labor resources. Also, the calculated cost indicatorsin different periods help to develop marketing and economical methods to reduce theirshare in profits.