The Accounting Equation

by Geoff Gannon


This is something that’s come up in emails readers and I have exchanged. If I was teaching an Investing 101 course, when students walked in on the first day this would be on the board:

Assets = Liabilities + Equity

Which means…

Assets – Liabilities = Equity

and…

Assets – Equity = Liabilities

This is taught in accounting classes to show how every transaction affects at least two of a company’s accounts and the equation always stays balanced.

I mention it just because it’s useful in situations like the blind stock valuation where I didn’t show the mystery company's liabilities. Some folks mentioned that I didn’t show the liabilities. Of course, I did show the mystery company’s liabilities because:

Assets – Equity = Liabilities

For balance sheets found in 10-Qs and 10-Ks filed with the SEC, it’s pretty common to just show the total assets and shareholder’s equity at the bottom of the balance sheet without totaling the liabilities. 

The reason for this is that for the sheet to "balance" you can't literally show assets on one side and liabilities on the other. You actually show assets on one side and liabilities plus equity on the other.

If you watched my eyes run down a balance sheet, the first thing I actually do – by force of habit – is race to the assets and equity at the bottom of the page to instantly see how leveraged the company is. Sometimes that’s all it takes to eliminate a stock from further consideration.

In theory, that bottom most number is liabilities plus shareholder's equity (which is on the line above it). But, since you know the accounting equation, you know that liabilities plus shareholder's equity is always equal to assets (Assets = Liabilities + Equity) so the two bottom most numbers are effectively a company's equity and assets. The difference between them is total liabilities.

So, the two bottom most lines of a balance sheet actually tell you a company's assets, liabilities, and equity in just one glance.

That one glance also tells you how leveraged the company is. If you see a lot of assets sitting below a little equity, that's a highly leveraged company. If the two numbers are close together, that's an unleveraged  company.

It can also be helpful to think in terms of leverage ratios. 

Like I do in my latest GuruFocus article about how Berkshire Hathaway uses leverage.

Talk to Geoff About The Accounting Equation