What is Balance Sheet Equation?

What is Balance Sheet Equation?

Definition

The balance sheet equation, which is also known as the accounting equation, is:

Assets = Liabilities + Shareholder’s Equity

This equation can also be written as:

Shareholder’s Equity = Assets – Liabilities

Or:

Liabilities = Assets – Shareholder’s Equity

What does balance sheet equation mean?

The balance sheet equation forms the basis of double entry accounting. Under the rules of this system, every transaction that a company carries out will result in two or more entries in its books. The accounting equation will always balance out.

When a new business is formed, the owner may contribute, say, $1,000 in capital. At that point in time, the position would be:

Assets = Cash of $1,000

Liabilities = Zero (as the company has not borrowed any money)

Shareholder’s equity = $1,000

This information can be put in the form of the balance sheet equation:

Assets = Liabilities + Shareholder’s Equity

$1,000 = Zero + $1,000

$1,000 = $1,000

We see that the balance sheet equation balances out.

Say, the company uses $500 of its $1,000 capital to purchase goods. This will result in its cash balance being depleted by $500 and its assets in the form of goods, rising by $500.

The balance sheet equation will now read as follows:

Assets = Liabilities + Shareholder’s Equity

$1000 ($500 in cash and $500 in goods) = Zero + $1,000

$1,000 = $1,000

Regardless of the size of the company or the complexity of its accounting records, the accounting equation will always be in balance. This is because in every instance where an accounting entry has an effect on a company’s assets there will be a corresponding effect on its liabilities.

Example of balance sheet equation

Wayne Schluman starts a food truck business. He puts up $50,000 as capital. He also takes a loan of $25,000 from his local credit union. With the $75,000 that is available, Wayne buys a fully equipped food truck for $45,000.

Wayne names his firm Schluman’s Sandwiches. This is the company’s balance sheet:

Balance sheet equation

Summary

As we can see the total assets are equal to the total liabilities + owner’s equity.

The balance sheet equation tells us that assets can be financed either from shareholder’s equity or from borrowed funds. At any point in time, the equation, Assets = Liabilities + Shareholder’s Equity, will balance.

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