In this article, we will just observe a simple scenario. Say you want to buy a car worth 5 lakhs and you have all the money to buy. So you approach the dealer and bought the car. Let us pause and ponder this simplest scenario.
You have cash of 5 lakhs and with that cash, you bought a brand new car worth 5 lakhs. Your cash 5 lakhs is totally converted into a car. I can represent this in math by,
Car = 5 lakhs.
Let us complicate a bit by increasing the car price to 7 lakhs. But you have only 5 lakhs. What do we do now? Of course, we borrow 2 lakhs from somebody. Now the above equation becomes,
Car = 2 lakhs (Borrowed) + 5 lakhs (Own)
Remember this observation and how we put this simple thing into the equation because this is the true essence of what we do next. Before diving further, answer me this simple equation. If you start a company XYZ, would you treat yourself and your company the same and integrate like your hand or leg. Are you and your company inseparable?
Well, the emotional answer would be yes but not rationally. Rationally your company is treated like another body that has its own set of rules and regulations. That's why you can't use the same Savings a/c of yours to the company. Banks expect you to start a new Current a/c for your company. This is because the purpose of existence is different for both. Your company exists to make a profit whereas your existence has to be found(kidding !).
So you and your company are different and not inseparable.Treat your business as different entity.
Next, when you start a company XYZ, you put in some money(say 10 lakhs). Same as buying a car except the business is treated as a different entity. Entity here just means treating business like another human being whose sole purpose is to make a profit. If I treat XYZ as another human being, I could easily conclude XYZ took 10 lakhs from me and kept it.
XYZ takes 10 lakhs = You give 10 lakhs
Since you give the money and the company has been started, we will only speak on behalf of company XYZ. Now, what company owns? Cash of 10 lakhs. To whom the company needs to repay? It's you i.e Owner of the company. Note: It is the company which speaks now.
XYZ owns 10 lakh = XYZ owes 10 lakh to owner
'owe' here means 'need to repay'
What a business owns need not be cash, it can be inventories, land etc. Therefore generalized equation would be
What business Owns = What business Owes to the owner
In accounting world,
What business owns is called 'Assets'
What business owes is called 'Equity'
Therefore,Assets = Equity
The above equation is the most fundamental equation of any business. If the left-hand side is not equal to the right-hand side, your company is said to be unbalanced and seriously in trouble. I hope you find it helpful.