Back to finance again. I wrote about TR = TE, the Income Statement and the Cash-Flow statement before. This post is about three letters and financial algebra that turn walls of text and numbers in to T-accounts and ledgers so you can separate assets from (owners) equity from liabilities. Of all equations in finance this the is holy grail, yes the accounting equation of A = E + L.
The visual form of the accountancy equation is the balance sheet. This is basically the final T-chart with a left side for assets (and liquidities) and a right side for the liabilities. The balance sheet by convention is titled, dated and described as “the balance sheet” to avoid any kind of confusion. The balance sheet has to do one thing first and foremost: present what you see as “what you see is what you get (on this moment in time).”
Basic Aspects of A = E + L
Assets = add value
Think of the supplies and equipment needed for production and sales.
Cash = asset
When running a business you need cash for small and short-term expenses.
Liabilities = claims
Think of the financial claims owners, investors and money lenders have.
Owners equity = financial claims of the owners
Per business entity the owners may vary.
Liabilities of non-owners = loans and credit
For every good and service that has not been paid for, a liability on the right side appears.
The basic aspects are simple to understand and easy to draw out. When you have experience with running a business or analysing businesses financially you use A = E + L as a tool. When a business is doing well assets tend to increase and cash thus cash-flow is always in positive or increasing.
When a business is not doing well the assets are under pressure. There are two typical ways in which a business is not doing well and the A = E + L is instrumental.
- Sales are good, collecting the sales revenues is going badly. So in assets cash and cash-flow are decreasing while liabilities for production and sales are increasing which puts the assets under pressure. Many businesses start with a loan.
- Sales are bad, the revenues are low and in assets the cash and cash-flow are decreasing while outstanding loans and credit are still in place which puts the assets under pressure.
This is only the starting point of what you can do with A = E + L…