In this example, we will demonstrate how assets, liabilities, and equity work together using orange juice and three glasses.
Let’s say we create a new company.
What do we need for that? Cash, right? Where do we get it from? Well, one way is that as the owners of the company, we’re going to put in our own private money into this company.
That’s called the equity.
We’re going to show this with a glass of water.
I marked the current level of equity with a green line here, but here’s the thing.
For most startups, its own equity is not enough. We need additional funds and we’re going to get a bank loan.
In our example, this glass of orange juice represents our bank loan.
I marked the current level with a red line.
Now currently, we only have balances on the credit side of the balance sheet. The balance sheet doesn’t balance, so what’s missing?
Credits represent the source, meaning where the money’s coming from. We are missing the debits.
Debits represent a destination, meaning where does the money go to? Or, what is it spent on? In our case, we didn’t spend it on anything yet.
All the money went to the cash account.
The cash account consists of the money we got from the owners and from the bank.
So, by just looking at the cash account, we can’t distinguish what came from where.
So, how much is our own funds and how much is externally financed? It’s just cash, orange juice with water.
What does the company do with its cash? It’s probably going to invest. Maybe it’s going to buy machinery.
Now, how does that affect the balance sheet? We take money out from the cash account and we put it into equipment.
The total amount of assets doesn’t change by that. We have less money in the bank but in exchange, we have the value of the equipment.
Now, if you start using the machine, it’s going to lose its value because we’re using it.
In accounting, this is reflected by depreciation.
Also, the company incurs expenses like personnel costs for its employees, because we have to pay salaries and wages, and these are taken out of the cash account.
In both cases, the financial value of the company decreases.
At the same time, our customers are happy and they pay for the products and services they got from us.
So we get money from them in our cash account.
Now, we want to know if in total we increased the financial value of the company since we started.
What do we need to do? We need to add up the value of the assets available at this point.
So which assets do we have? We have the current value of the machinery, which is what we initially paid for, minus the depreciation, so which is the decrease in value because of wear and tear, plus what we currently have in the bank.
That’s the total assets of the company.
Now, from this total, we need to deduct the debt of the company.
We can see this with the red marker on the glass.
Now, if the value of the remaining assets is higher than the original equity the owners paid in, the company made a profit and increased its financial value.
Let’s check. If it’s less, we made a loss. Now in our case, it’s higher than the green line, so we made a profit and increased the value of the company.
The important part of this exercise is that the glass with the equity was always empty.
That’s because equity on its own doesn’t really exist. What exists are the assets of the company and its debt. Equity is just a calculation of total assets minus debt.
It exists only on paper. The more assets a company has and the smaller its debt, the bigger equity will be.
It all comes back to the main accounting equation: assets equal liabilities plus equity.
If we rearrange this, equity equals assets minus liabilities.
The higher value for assets and lower value for liabilities, equals higher equity.