Understanding Equity (And Why a Balance Sheet Balances)

Why does the balance sheet balance?  And what do those “equity” entries mean, anyway?  After all, equity isn’t something the company owes anybody else.  So why does it appear on the same side of the balance sheet as the “liabilities” entries, which show that the company owes?

First, let me share an interesting fact about the balance sheet.  The left side- the assets side – shows the money value of things.  It shows cash in the bank, money that’s owed the business, physical objects such as buildings and equipment, and intangible assets such as goodwill.  The right side – the liabilities and equity side – is a little different.  Sure, it’s still numbers.  But those numbers represent peopleThey represent liabilities the company has incurred to the people who are its creditors.  They represent the value held by the people who own the business (equity).  The balance sheet is a snapshot that connects things to people.

So equity is pretty simple – it’s all the money that the company theoretically owes the owners of the business after everything it owes all creditors has been accounted for.  Another way of saying it?  Assets equal liabilities plus equity.  (Accountants call this the basic accounting equation.)

So that’s why the totals on both sides of a balance sheet are identical.  It’s why a balance sheet balances.  Of course, accountants don’t just subtract the liabilities from the assets and assume that whatever they get is the correct number for owners’ equity.  They have to add up common stock, paid-in capital and retained earnings, and be sure that the total equals assets minus liabilities.  This can sometimes be a daunting task, which is why the world needs accountants after all.

It’s also why equity appears on the “liabilities” side of the sheet.  If you’re a business owner, one thing you want to know from a balance sheet is, how much do I or we, or the shareholders) have left over after we take into account everything that is owed to other people?  Add up the assets, subtract liabilities, and presto:  there’s what your ownership in the business is worth, according to accounting rules.

Why did we put in that qualifier, “according to accounting rules?”  Well, remember the explanation above: if you sell your stake in a business, it’s going to be worth whatever someone wants to pay for it.  What the balance sheet shows is book value – that is, what your assets minus your liabilities are worth according to historical cost, depreciation, and all the other rules accountants use to calculate their value.

This is the 4th blog of 5 blog series that will be posted this week to help you understand one aspect of running a business that is crucial to be able to make informed business decisions for your business. Check back tomorrow for more content.

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