UNDERSTANDING ACCOUNTING TALK 2: Net Worth

The basic accounting equation:

Assets = Liabilities + Equity or Assets – Liabilities = Equity

is plain common sense. Whatever you’ve got (your assets), either you bought with your own money (your equity) or you borrowed or bought with borrowed money (your liabilities). Equity is often called Net Worth –your real worth net of your liabilities or after deducting what you owe.

You or your business may have cash (an asset) of a million dollars, but this asset only becomes your or your business’ real worth if you do not owe anything to anybody. Consider somebody or a business with cash of a million dollars but $999,900 of which are borrowed. The real worth (or Net Worth or Equity) of this person or business is only $100. This person or business is just as wealthy as anybody who only has cash of $100, but who does not owe anything to anybody.

Of course, in the real world, the capability to borrow $999,900 has real value. This is considered an asset only as an analogy, not in the accounting sense. In the jargon of the business world, this is an off-balance sheet asset.

But then again, in the real world, who would lend $999,900 to somebody who only has $100 as an accounting asset. The world, especially the business world, looks at what you’ve got (your assets) and carefully considers whether or not there are other claims (liabilities) against these assets besides yourself.

As an exercise, look at / list everything you’ve got. List everything you borrowed and what you owe. When you deduct what you borrowed and what you owe from what you’ve got, that is your real worth, your equity, your net worth.

With this simple exercise –believe it or not– you are doing accounting.