No, it is not debits and credits, or the benefits of bonus depreciation. The single most important accounting concept that any business owner needs to understand is a simple mathematical equation:
Assets = Liabilities + Equity
This is the formula that defines every company’s balance sheet. What's more, the relationship between assets, liabilities and equity forms the fundamental basis of all economic wealth. Here how it works.
Your assets are everything your business owns. But they didn't just drop from the sky and fall ito your lap. Assets are financed: either through debt you take on (liabilities), capital you've built (equity) or by retaining and spending profits (equity).
By the way, this same equation applies to all of our personal assets as well. This may be an easier way to understand this important accounting equation.
Think about two or your key personal assets such as your car and your home. Perhaps you took out a loan to acquire them and also made a down payment. The loan represents a liability and the down payment represents equity.
In your personal life, the more of your salary you save, (Income – expense), the more net worth you build (Equity). The same thing applies to business. The great the profits you generate and put back into the business, the more you increase your assets without increasing your liabilities.
If you jigger the equation slightly to Assets –Liabilities = Equity, this essentially means that your net worth (Equity) is the difference between your assets and liabilities and the more you pay off your debt, the greater your net worth.
This simple equation, and the relationship between its three variables, is the fundamental basis of all economic wealth. So it is important to understand how to apply it in growing your own business.
We will delve into this topic in our next blog post.