This is what we seek in all aspects of our lives. The right amount of good and bad moments to help us stay grounded. Not too good that we lose our character and not too bad that we lose our identity.
It is no different in corporate financial accounting.
There is always a balance between the resources an entity has at its disposal and the capital that has been deployed to the entity.
There is a fundamental accounting equation that governs the statement of an entity’s financial position (formerly known as balance sheet).
Assets = Liabilities + Owner’s Equity
Assets are resources.
Liabilities and Owner’s Equity are capital.
It is a simple and profound way of checking an entity’s health at a point in time.
The equation does not tell you whether the entity is good or bad, it just tells you that as at the time you are assessing any entity there must be a balance between total Assets and the sum of total Liabilities and Owner’s Equity.
Where that balance does not exist, there is an error in some transactions that have been posted for the company.
It is important you understand the space a company is operating before drawing insights from its balance sheet. Without domain knowledge, your conclusions will be misleading no matter how well thought through.
In some industries, financial health involves having a higher proportion of Liabilities to Owner’s Equity but it can be vice versa in other industries.
In some industries, the size of the assets are all that matter, and in others, pass marks are only given to those that keep assets low.
Warren Buffett has a famous quote: “Never invest in a business you cannot understand.”
However, when a company has no Owner’s Equity, then all of its Assets are Liabilities. An investor should think twice before entering such a company because all relationships within it will be transactional. Companies that are a going concern require the commitment and risk that ownership provides.
Back to the fundamental accounting equation.
All equations with an equal sign can be re-written by moving the characters from left to right or right to left, thus inversing them.
Assets – Liabilities = Owner’s Equity
Assets – Owner’s Equity = Liability
The equation can be written in three ways and it is important to remember all three when analyzing an entity’s statement of financial position.
As an aside, the good thing is that the equation also applies to individuals. You can draw up a statement of your own financial position as at today. You might be shocked to see that the imbalance you find in many other aspects of your life is because you have not balanced your fundamental accounting equation. Too many transactions are slipping by without you noticing.
A logical question is, “how do you post transactions in such a way that all Assets are always equal to the sum of all Liabilities and Owner’s Equity?”
This is where an important convention is called in. It is called double entry bookkeeping (or double entry accounting).
Recall that we discussed bookkeeping earlier.
We will discuss double entry in our next post.
#MEMBA11 #CFA #Zazparelli