Balance Sheet Equation

BALANCE SHEET EQUATION
Introduction of Balance Sheet Equation

The fundamental part of accounting and the most basic
equation in accounting is the Balance Sheet Equation. It forms
the base for a double-entry accounting system.
The Balance Sheet shows the company’s total assets and how
these assets are financed, i.e. through debt or equity. The
balance sheet shows stake owners of the business, and that is
how we come up with the balance sheet equation as:
Assets = Liabilities + Equity
Components of the Balance Sheet Equation

Balance sheet components show how the balance sheet is
structured, and three major components are Assets, Liabilities,
and Shareholders’ Equity. They are further divided by:
1. Assets
 Current Assets: Assets, which are expected to be
converted into cash generally within a year.
o Cash and Equivalents: A most liquid asset in the
balance sheet, while assets with short term, i.e. under

three months maturity, are also considered under cash
equivalents. Cash equivalents can be liquidated easily if
needed.
o Account Receivable: Revenue which is still on credit.
As the company recovers account receivable, this

amount decreases while the company will get the same
amount of cash.
o Inventory: Amount of raw materials, Work in
Progress, and finished goods that have not been sold.

 Non-Current Assets:
o Property, Plant, and Equipment: These are
generally long-term assets. Most of these items are

generally recorded after the deduction of depreciation.
o Intangible assets: In this section, the company
includes assets that may not be identifiable. It includes
Patents, Licences, Goodwill, etc.
2. Liabilities
 Current Liabilities: Liabilities, which has to be paid and
settled within a year by the company.
o Accounts payable: Amount of money the company
owes to suppliers or services bought on credit. As the

company pays off its account payable this amount, gets
reduced with the same reduction in cash.
o Accrued expenses: Bills, which are, still need to be
paid by the company. These items include general

expenses like distribution expenses etc.
 Non-Current Liabilities:
o Long-term debt: Long-term debt is generally the
company’s projects, which are financed for a long

period, or assets bought by the company for a long-term
purposes, which are financed by loans, Bond issues,
Capital leases, etc.
Importance of Balance Sheet Equation

The importance of the balance sheet equation is:
 Foundation of Accounting: Balance sheet equation set
base for a double-entry accounting system, which considers
every transaction in the company will have two entries in
books of accounts.
 Assets = Liabilities + Equity Logic: The logic of the
Balance sheet equation is every asset in the company is
financed by liability, i.e. Debt (Short or long-term), or by
equity, i.e. by owners capital invested in the company.
Mismatch on both sides helps accountants and finance
professionals point out quick mistakes made in building
books of accounts.
 Represents Stake owners interests in
business: Balance sheet equation shows:
 Assets: Which are owned and controlled by the company.
 Liabilities: Obligation, which companies have to pay off.
 Equity: Owners’ investments in the business.
 Shows the company’s liquidity, leverage, Financial
capacity, growth:
o Liquidity: The balance sheet reflects how the company
can pay its short-term obligations.

o Leverage: How much the company’s activities are
financed by debt and whether the company can pay off

this debt or not.
o Financial Capacity: The balance sheet shows the
financial capacity of the firm and how assets are

financed, the ability to pay off its debts, the efficiency of
turning assets into revenue and cash management.
o Growth: Overall view of the balance sheet shows how
the company is performing over a period. Ability to

generate returns through various assets, which are
financed by equity and debt.
 Universal application: The balance sheet equation is
applicable everywhere, which makes regulators, companies,
and the public to understand the financial statements of any
company.
Advantages
Some of the advantages are given below:
 Risk and returns: The balance sheet shows the assets
and liabilities of the company. It shows the ability of the
company to pay out its short-term liability as well as the
ability to settle long term debt. At the same time, it also
shows whether the company can generate returns compare
to the risks (debt) and overall growth structure of the
company over a period.
 Helpful to secure loans and additional investments:
Due to the balance sheet equation, reading and
understanding of balance sheet become easy and useful for
lenders and new investors. It helps them to understand the
company’s financial ability to pay out its debt and grow in
the future, which further help them to decide to invest in a
company or not.
 Ratio calculations: The balance sheet equation is the
base part of the double-entry accounting system. It helps us
to understand various ratios. E.g. the current ratio provides
liquidity status, the debt to equity ratio provides leverage
status, etc. For investors as well as businesses, these ratios
are important as they reflect how well the current structure
and operations of the company are well managed.
Disadvantages
Some of the disadvantages are given below:
 Misstated long-term assets: The balance sheet records
the value of long-term assets at historical prices instead of
current value. Book value can create a distortive picture of
the company’s financials, as it underestimates long-term
assets.
 Need comparison: To understand the balance sheet as
per the balance sheet equation and making investments or
business decision needs comparison of the balance sheet of
peers over many years.
Key Points
 The balance sheet equation or accounting equation is the
base for the double-entry accounting system.
 Asset = Liabilities + Equity ( Logic every asset is financed
by debt or equity)
 Financial capacity: Financial equation helps us to
understand the company’s financial structure and ability to
pay off its debt and grow over the years.
 The universal equation helps financial professionals,
business owners, and investors understand, compare, and
make investment decisions.

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BALANCE SHEET EQUATION

Introduction of Balance Sheet Equation

Assets = Liabilities + Equity

Components of the Balance Sheet Equation

balance sheet, while assets with short term, i.e. under

As the company recovers account receivable, this

Progress, and finished goods that have not been sold.

generally long-term assets. Most of these items are

owes to suppliers or services bought on credit. As the

paid by the company. These items include general

company’s projects, which are financed for a long

Importance of Balance Sheet Equation

can pay its short-term obligations.

financed by debt and whether the company can pay off

financial capacity of the firm and how assets are

the company is performing over a period. Ability to

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