In this lesson we're going to use the accounting equation to evaluate the financial position of a business in three scenarios.
What is Financial Position?
Financial position refers to the financial situation a business finds itself in at a specific point in time.
One business might be in a good financial position at a certain point, another may be in a bad position. Or the same business might be in a good financial position one year, but a few years later its financial position is poor.
The main indicator of financial position is the business's ability to pay its liabilities(debts).
In other words, how much assets does the business have relative to its debts.
The Accounting Equation and Financial Position
The three elements of the accounting equation - assets, owners equity and liabilities - when compared to one another, show us a business's financial position.
The following three examples will illustrate this...
Would you invest in the following business?
Probably not. 90% of the assets of this business will be used to pay debts in future.
The owner's equity, which reflects the net worth of the business (the real worth to the owner or owners) is only $10,000.
The financial position of this business is thus poor.
What about this business – would you invest in it?
What on earth is going on here? Negative owner's equity - is that even possible?
Well, one thing is for sure: in this case you certainly would be quite apprehensive about investing.
The total liabilities (debts) of the business are greater than the assets it has to pay off these debts. As a result the owner or owners are stuck with a loss.
Or in other words, the owner or owners may have to fork out $20,000 out of their own pockets (from their private funds) to pay the liabilities.
Where the total debts of the business are greater than its assets, we say that the business is insolvent. This means that it cannot pay all its debts.
Obviously the financial position of this business is terrible.
Now how about this business?
This business looks a bit healthier.
The business can comfortably pay all of its debts. In fact, only 40% of the assets will be used to pay the debts – 60% of the assets are really owned by the owner (owner's equity).
The owner's equity or net worth of the business is $60,000.
The financial position of this business is quite good.
A Quick Note on Debts
Bear in mind that it's not always a bad thing to have debts.
For example, where you have a project that you estimate will bring you a $40,000 return, but you need to invest $5,000 to start with (and you don’t have the money yourself), it would be a wise move to borrow the $5,000 (thereby creating a liability of $5,000 towards the bank).
Maybe it takes you a year to pay the debts, which comes to $6,000 in total after all the bank charges and interest. Well, you’ve still made $34,000 from this ($40,000-$6,000). Not bad, eh?
The financial position of a business is shown in a special accounting report called the balance sheet,also known as the statement of financial position.
The balance sheet lists out the assets, liabilities and owner's equity for a business at a specific point in time.
The balance sheet is one of the components of the financial statements, the key financial reports of a business, which we cover in a later chapter.