By DeVry University
Accounting is full of various equations and formulas that are designed to help you quickly and effectively acquire information about the financial standing of your business. Among these many formulas is the famous accounting equation, which is used to calculate the total value of the assets held by your company.
In a situation where the business has a sole proprietor, the formula is as follows:
Assets = Liabilities + Owner's Equity
For publicly held corporations, the formula is the same, but the concept of “owner” is slightly modified:
Assets = Liabilities + Shareholder Equity
And as any accountant knows, having a clear picture a company’s finances and what it has on hand is one of the most important elements in making good financial decisions, and why the accounting equation is so critical.
In this article, we'll dig into each element of the accounting equation and explain some of its applications in order to help you become more familiar with the formula. You'll learn about all of these things and more as we explore the following sections (jump to):
Elements of the Accounting Equation
As you can see from the accounting equation itself, there are three elements that make up the whole formula — assets, liabilities and equity. Here's a brief explanation of each element and why they are important to your ability to properly perform accounting tasks.
Assets are any resources owned by a company. For instance, if you ran a lumber company and had 70,000 lbs. of lumber sitting in a warehouse, that would be considered an asset. Assets also include non-physical holdings, such as prepaid insurance and investments. In order for your accounting to be clear and correct, your assets must always equal the amount of liability plus equity, whether held by shareholders or a sole proprietor.
Liabilities are considered to be anything that is a claim against the company's assets, such as payments or debts that the company owes. Ultimately, liabilities have a negative value representation, and are offset using the double accounting principle. For example, if your company secured a loan from a bank for $10,000, assets would increase by $10,000, as would liabilities.
Equity is any amount of money remaining after liabilities are subtracted from assets. Due to the nature of the accounting formula, other elements can be moved around as needed to solve for unknown variables. For instance, if you did not know the equity of the company but did know the liabilities and assets, you could subtract liabilities from assets in order to determine the equity. In scenarios where the company is publicly traded, you could then determine individual shareholder equity by calculating the total company equity and then pulling the percentage owned by a particular shareholder.
Example of the Accounting Equation
To help you better understand how the accounting equation works, here is a quick example of how the equation can be used.
Let's say that you are aiming to calculate the total assets owned by the company. In this scenario, you would follow the basic accounting equation formula of Assets = Liabilities + Owner Equity. For this example, let's assume that you have $1000 of liabilities and the owner equity is $5000. You could use the formula in the following manner:
Assets = -$1000 + $5000 Assets = $4000
Common Applications for the Accounting Formulas
The accounting equation has a few expanded versions that can be used to calculate different variables, but there are also dozens of different accounting formulas that accountants use to identify crucial elements of a company's finances. Here are a few of these equations along with a brief explanation of how they work.
Gross profit refers to the total amount of profit left after expenses associated with providing goods or services are removed. Gross profit, also known as gross income, includes only variable costs and does not account for the fixed costs of a business that are not directly attached to production. To calculate the gross profit of sold items, you would use the following formula:
Sales - Cost of Goods Sold = Gross Profit
Gross Profit Margin
Gross profit margin takes the gross profit figure you obtained from the gross profit formula and then divides it by total sales in order to identify the percentage of each sale that you retain every time a product is sold. The formula used to calculate this number is:
Gross Profit / Sales = Gross Profit Margin
Net income takes the gross profit figure and then subtracts other expenses that are not necessarily associated with the cost of product creation. For instance, the gross profit calculation would not include fixed expenses such as executive salaries or office rent. To calculate the net income of your company, you would use the following formula:
Income - Expenses = Net Income
The break-even point is the point at which your gross income exceeds that of all your expenses across the company. The primary goal of all companies is to reach this point and then continue to increase sales in order to increase overall profits. The following formula is used to calculate the break-even point:
Fixed costs / (Sales price per unit - Variable cost per unit) = Break-Even Point
Cost of Goods Sold (COGS)
Cost of goods sold is a figure used to determine the overall cost that the goods required to produce, including materials and labor. This figure is useful for determining sale price as you can use it to set your overall profit margin for a certain good. The formula used to arrive at this figure is:
Beginning Inventory + Purchases of the Inventory - Ending Inventory = Cost of Goods Sold
Current ratio shows you the present standing of your company in terms of how many assets your company has compared to its liabilities. Typically, you want to have a higher ratio as that indicates you have more assets than you do liabilities. The following formula can help you identify the current ratio of your company:
Current Assets / Current Liabilities = Current Ratio
Start Your Accounting Education at DeVry
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Discover more about the primary accounting equation, other accounting formulas and their applications from knowledgeable faculty applied to real-world issues. Classes start every 8 weeks. Contact us to learn more.