Assets, liabilities and equity
“Why does the balance sheet always balance?”
Every accounting question ends with “and the balance sheet balances”. Knowing why makes the harder questions feel obvious.
Everything a company owns was paid for by someone: lenders and suppliers (liabilities) or owners (equity). So assets = liabilities + equity, always.
Two sides of the same stuff
The left side lists assets: things that will bring in value, like cash, money customers owe (receivables), inventory, equipment and buildings. The right side says who paid for them: liabilities, money owed to banks, suppliers and staff, and equity, the owners' stake.
Because the right side is just a list of who funded the left side, the two totals must match. Borrow money, and cash and debt both rise. Buy a truck with cash, and one asset becomes another, so the total doesn't move.
- 1Assets: cash $200 + ovens $500 + flour $200 = $900.
- 2Liabilities: bank loan $400 + unpaid supplier bills $150 = $550.
- 3Equity = assets − liabilities = $900 − $550 = $350.
Predict it: up, down, or the same?
Current vs long-term
Items expected to turn into cash, or be paid, within about a year are current: cash, receivables, inventory, supplier bills. Everything else is long-term: buildings, equipment, a five-year loan. Bankers look at current items to judge whether a company can pay its near-term bills.
Equity isn't cash sitting in a box. It's a claim: what would be left for the owners if every asset were sold at book value and every debt repaid.
Say it like this
The balance sheet balances because it shows two views of the same resources. Assets are what the company owns. Liabilities and equity show who paid for those assets: creditors through liabilities, and owners through equity, which includes the money they invested and the profits the company has kept. Every transaction changes both sides by the same amount, or swaps one item for another on the same side.
Traps to avoid
- ✕Thinking a transaction can change only one side. It changes both, or swaps items on one side.
- ✕Calling equity the same as the company's cash.
- ✕Listing a loan the company made to someone else as a liability. Money owed to the company is an asset.
What they'll ask next
›What's retained earnings?
The running total of profits the company has kept instead of paying out as dividends. It sits inside equity.
›Can equity be negative?
Yes, if liabilities exceed assets, for example after years of losses or a big debt-funded dividend.
›Is inventory current or long-term?
Current: it's expected to be sold, and so turned into cash, within a year.
Check yourself
Which equation must always hold on a balance sheet?