Before we consider any accounting implications, let’s think about what Bill needs before he can start his business. After a brainstorming session, Bill comes up with the following list:
- Lawnmower, trimmer, leaf blower, & other equipment
- Work Truck
- Lawncare products to sell to customers
- Spare Cash
These are all items that the business will own and that it will use to make money. Accountants group these things together and call them assets.
Don’t ever let your business get ahead of the financial side of your business. Accounting, accounting, accounting. Know your numbers.”
Tilman J. Fertitta, Owner, Houston Rockets
Bill doesn’t skimp on his equipment. He buys new, industrial-grade products that he plans to use for many years. The total cost is $2,000. For his work truck, he buys a used, regular cab, two wheel drive vehicle with high mileage, planning to use his own expertise and skills to keep it running. It costs $4,000.
Thanks to a longtime friend involved in manufacturing, Bill can acquire high-end lawn fertilizer at discount prices. He will be able to sell these to customers for less than what they would pay at a home improvement store, while still making a profit. He buys 300 bags of fertilizer for $5 per bag. This stock of fertilizer that he plans to sell is called inventory.
Finally, he decides to keep $2,500 of cash on hand to cover operating expenses and emergencies.
Bill makes a list of everything his company now owns (assets) that looks like this:
There are two ways Bill will finance these needs. First, he takes out a $5,000 small business loan in the company’s name. Anytime a business owes something to another entity, accountants call this a liability. Usually, this is debt, but it could be something else, such as products or services the firm is obligated to provide in the future.
Second, Bill contributes $5,000 of his own money that he has saved for this purpose. The accounting term for the portion of a business funded directly by the owners is owner’s equity. You could also think of equity as the difference between everything the company owns (assets) and everything it owes (liabilities). This is similar to the concept of equity as applied to a house, which is the home’s value minus the outstanding amount of the mortgage.
After securing funding for these initial purposes, Bill updates his list of assets to also show how he financed the purchases:
It’s important to note that the total amount of the two financing methods must equal the total amount of everything the business owns. The money to purchase the assets has to come from somewhere, and the source can always be classified as either a liability (a debt), or equity (owner contribution).
Not only is this true at the beginning of a firm’s existence, it must remain true as long as the firm continues to operate. A company’s assets must always equal its liabilities plus its owner’s equity. This idea is so fundamental that it is referred to as the accounting equation.
Put in simplest terms, the equation is this:
Assets = Liabilities + Owner’s Equity
A business cannot record a transaction that takes this equation out-of-balance. If Bill’s lawn care buys $500 more fertilizer using cash on hand, the inventory asset increases to $2,000. Since the purchase was in cash, the cash asset decreases by the same $500, keeping the total assets equal to the total liabilities plus equity.
If Bill decides next that he needs a new mower and leaf blower and increases his loan at the bank by $1,000 to cover the cost, then the equipment line and the loan line both increase by the same amount.
Finally, Bill could take some cash out of the business. If he takes out $500, this reduces cash and owner’s equity.
When a business pays cash back to the owners like this, it is known as a dividend.
Just by trying to keep track of what his business owns and how those things were financed, Bill accidentally created a fundamental financial statement known as a balance sheet. We’ll get more into the balance sheet in the next section. We’ll also assume that Bill didn’t really make the three example transactions above. His starting point will be the original asset listing totaling $10,000, with financing of $5,000 each of liabilities and equity.