This is the Accounting equation
Assets = Liabilities + Owner's Equity
This is the expanded version of the Account equation:
Assets = Liabilities + Owner's Capital + Revenues - Expenses - Owner's Draws
WTH! What is this supposed to mean?
Why should a founder know this?
A business is about making money. Accounting keeps track of your business financials. To understand the health of your business, you need to understand your business financials. To understand business financials, you sort of need to understand how accounting is done. One aspect of the accounting process is the accounting equation.
What about the accounting equation?
Definition:
- Assets - Something of value that you have
- Liability - Something that you owe someone else
- Revenue - Income from customers
- Expense - Expense related to running the business
- Owner's Capital - Money put in by the owner when starting the business
- Owner's Draws - Money taken out of the business by the owner as drawings
Every entry made in your accounting tool must validate this equation. The sum of all the entries in your accounting tool should also validate this equation. Thats how accounting entries are made.
Example 1: You sold something to customer and collected cash.
Sales is recorded as revenue. Cash is recorded as Asset.
Example 2: You sold something to customer but did not collect cash
Sales is recorded as revenue. Account receivable(money you need to collect from customer) is increase by the same value. Account receivable is an asset. Its something you can show investors or bank as a certain kind of asset.
Example 3: You took a loan
Loan is a liability, you need to pay it back. So liability increases. Loan gives you cash. Cash is an asset. Equation is valid.
Founders perspective
I feel like the current format of the accounting equation is meaningless for the founder. It feels like something that the accountants use. Here is the format that makes sense to me as a founder with an engineering background. This is easier for me to remember.
Owner's drawings = Owner's capital + Revenue - Expense + Liability - Asset
Owner's Drawings is the money that the owner can draw for themselves. This is money you can take out of the business. This is the founders perspective. What can we do to increase the money we can draw out of the business?
If you look at the equation, it shows the following:
If you increase revenue, you can draw more.
You want to take money out of the business, figure out a way to increase your drawing.
If you decrease expense you can draw more:
If you reduce your expense, you have more money for yourself. Great you can increase your drawing.
If you increase liability you can draw more:
Yes, if you take a bank loan, it will come an sit in your company bank account as an asset. In the equation, if you dont let the cash sit inside your company account, you can mark the asset as zero and draw the money out for yourself.
DO NOT DO THIS. Just saying that the accounting equation holds true. More liability you have, more you can draw.
If you increase your assets you can draw less
Lets say your company bought a property. You can now draw less money as the money was used in purchasing the property.
Why know this?
Why know this equation? This equation is obvious right? whats the big deal?
It helps you read financial statements. It helps your read transactions recorded in your accounting statement. An entry made in the books will have debit and credits. You should know the equation to know when something gets debited or credited.
To know more about debits and credits - check out debit or credit - a founders perspective
