Introduction to the Accounting Equation
From the large, multi-national corporation down to the corner beauty salon, every business transaction will have an effect on a company's financial position. The financial position of a company is measured by the following items:
- Assets (what it owns)
- Liabilities (what it owes to others)
- Owner's Equity (the difference between assets and liabilities)
The accounting equation (or basic accounting equation) offers us a simple way to understand how these three amounts relate to each other. The accounting equation for a sole proprietorship is:
The accounting equation for a corporation is:
Assets are a company's resources—things the company owns. Examples of assets include cash, accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment, and goodwill. From the accounting equation, we see that the amount of assets must equal the combined amount of liabilities plus owner's (or stockholders') equity.
Liabilities are a company's obligations—amounts the company owes. Examples of liabilities include notes or loans payable, accounts payable, salaries and wages payable, interest payable, and income taxes payable (if the company is a regular corporation). Liabilities can be viewed in two ways:
(1) as claims by creditors against the company's assets, and
(2) a source—along with owner or stockholder equity—of the company's assets.
Owner's equity or stockholders' equity is the amount left over after liabilities are deducted from assets:
Assets - Liabilities = Owner's (or Stockholders') Equity.
Owner's or stockholders' equity also reports the amounts invested into the company by the owners plus the cumulative net income of the company that has not been withdrawn or distributed to the owners.
If a company keeps accurate records, the accounting equation will always be "in balance," meaning the left side should always equal the right side. The balance is maintained because every business transaction affects at least two of a company's accounts. For example, when a company borrows money from a bank, the company's assets will increase and its liabilities will increase by the same amount. When a company purchases inventory for cash, one asset will increase and one asset will decrease. Because there are two or more accounts affected by every transaction, the accounting system is referred to as double-entry accounting.
A company keeps track of all of its transactions by recording them in accounts in the company's general ledger. Each account in the general ledger is designated as to its type: asset, liability, owner's equity, revenue, expense, gain, or loss account.
We created a visual tutorial to demonstrate how a variety of transactions will affect the accounting equation and the financial statements. It is available in AccountingCoach PRO along with test questions that pertain to the accounting equation.
Balance Sheet and Income Statement
The balance sheet is also known as the statement of financial position and it reflects the accounting equation. The balance sheet reports a company's assets, liabilities, and owner's (or stockholders') equity at a specific point in time. Like the accounting equation, it shows that a company's total amount of assets equals the total amount of liabilities plus owner's (or stockholders') equity.
The income statement is the financial statement that reports a company's revenues and expenses and the resulting net income. While the balance sheet is concerned with one point in time, the income statement covers a time interval or period of time. The income statement will explain part of the change in the owner's or stockholders' equity during the time interval between two balance sheets.
How to easily perform a break even analysis
It is easier to start with the definition of the break-even analysis or to be more precise with the break-even point.
The break-even point is the point where the total contribution of the sales equal to the fixed costs. In other words, the break-even point is the point where the total revenue less the variable costs from the sales made equal to the total fixed costs.
Break-even analysis is the analysis that is performed to identity how many sales a company needs to make to cover it’s fixed cost base.
A simple example might be more helpful. Let’s say that company A sells one product only which is called SuperGlass. The price is the same ($10 per unit) for all customers and it is not expected to change. The material cost $6 per unit while the company has fixed costs of $10,000.
The contribution per unit is $4 ($10-$6) and therefore, the company will need to sell 10,000/4=2500 units to break-even.
Break even Analysis Formula
Break even Analysis for two or more products
A more realistic scenario is that a company is producing more than one product. So the question is how to perform a break even analysis for two, three or fifty products. It is actually quite simple!
Let’s say that company A is producing SuperGlass and ExtraGlass and that the company is expected to sell 2 units of SuperGlass for every unit of Extraglass (2:1). The table below summarizes the price per unit, the variable costs and the fixed costs. [table id=2 /]
The first thing to do is do to add the contribution for both products so that we can create a “combo” that consists of these two products. The total contribution for this combo $10 (4+6).
Therefore, the break even point is 100,000/10 or 10,000 units. The company will therefore need to produce 10,000 * 2 from SuperGlass and 10,000*1 from ExtraGlass to break even.
Break-even Analysis Chart
It is quite easy to create a chart for a simple break even analysis. The first thing to do is to put the fixed costs in Y axis and the Contribution generated for different levels of sales on the X axis. The result is going to be the same as the photo featured in this post.
It is clear from the graph the break even point is where the total income less the variable costs equal the fixed costs.
Break-even Analysis Uses
Break even analysis can only help you to identify the level sales you need to make to avoid being in a loss making position. It can help you to understand if the product you are thinking to develop can be profitable by indicating how many units you need to sell to break even. If in your opinion, the level of sales is easily achievable then the product should be developed. If the necessary to break even level of sales seem to high, then the investment might not be worthwhile.
Break-even Analysis Limitations and Disadvantages
Break-even analysis has as any other similar analysis tool flaws. Some of them can be summarized as follows:
- It can only help you analyze straightforward scenarios and it is hard to apply it in more complex scenarios.
- It is based on expected sales prices, expected variable and fixed costs which and expectations will not be objective.
- It does not account for the synergies that products can bring.
- It does not account for certain benefits that a product can bring (such as diversified portfolios, enhanced brand name etc.