by Tess Boardman

Created on: January 21, 2012

“I know my business, but I do not know anything about accounting,” is a common refrain by many business owners. However, every business owner should arm themselves with the basics of their financial picture. First, there must be a basic grasp of the basic equation used in accounting. Then, there are the terms themselves.

The basic accounting equation balances the assets with the liabilities and equity of a business. Simply stated:

Assets = Liabilities + Owners’ Equity

Assets, such as accounts receivable, equipment, land, are those items that can be converted to the most liquid of assets: cash. Liabilities are items that the business owes such as accounts payable, notes payable, and wages payable. Owners’ equity is the claim the owners have on the assets of the business.

Profit, in accounting, is a positive gain resulting from gross receipts less expenses in the course of conducting business. Loss occurs when the opposite happens – expenses exceed revenues resulting in a negative income. Profits and losses are reported on the income statement of a business. Once determined, the bottom line is carried to the balance sheet.

This is where capital comes in. Capital is the net worth of a business, determined by the assets and liabilities.  When comparing assets to liabilities, if assets exceed the liabilities, the excess is capital and part of the equity of the business.

When there is a profit on the income statement, it transfers to the equity section of the balance sheet. When there is a loss, equity is reduced whether directly to the owners’ equity account or due to an increase in liabilities.

For instance, a small, single-owner construction business reports gross receipts for the year of $300,000. After deducting normal expenses of cost of goods, wages, and operating expenses of $200,000, the business realized a net profit of $100,000. This net profit will impact the balance sheet. The gross receipts represent revenues. Revenues may be realized as cash sales or accounts receivable which are reported on the balance sheet. When receipts outweigh expenses, those asset accounts will increase. Expenses will affect both the assets and liabilities portion of the balance sheet. Accounts payable may be increased or cash may be reduced. With a net profit, the capital is increased.

On the flip side, if the business owner underbid a large project and had $400,000 in expenses with the same revenues, there would be a net loss of $100,000. This will result in a decrease in the capital of the business, giving the owner less claim to the assets.

Understanding the effect on capital by profit and losses will give the business owner a better picture of financial health. It begins with knowing that there is more to an owner’s claim on the assets than revenues alone and how the profit or loss fits into the accounting equation.

Learn more about this author, Tess Boardman.
Click here to send this author comments or questions.