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Two Basic Accounting Formulas Applied to Personal Finances

Basic accounting formulas for your personal finances
Did you get the chance to take an accounting course in college? Let’s review two basic accounting formulas you may have learned:

Assets = Liabilities + Equity

This “Accounting Equation” is the very basic foundation of double entry accounting. Every transaction has to make sure that this equation is in balance.

Using basic arithmetic principles, it can also be stated: assets – liabilities = equity.

Maximizing Equity

In personal finance, you’ll see equity referred to as net worth. And the goal is to maximize the equity/net worth.

There are two main ways to maximize your personal equity:

  1. Increase assets
  2. Decrease liabilities

Really, it’s that simple. In theory.

Add a house (more assets), pay off your mortgage (less liabilities) = net worth increase.

Stock values go up = increased equity.

Of course, reality is a lot harder than this. It can take years to pay off your mortgage. And in order to do that, you need money. Cold hard cash. From your job or other income producing sources.

Which leads to the second basic accounting formula that you need to know.

Revenue – Expenses = Income

In corporate accounting, income (loss) is defined as the revenue minus the expenses. It becomes a loss if the expenses are more than the revenue.

Of course, on the personal finance side, we define income as our salary. Because we are fun like that and like to keep everyone guessing about what we are talking about. No reason to be consistent, right?

In any case, the idea here is that all the money you take in, minus all the expenses you pay out determines whether you are making money.

And we like to make money!

Interplay Between the Two Formulas

Basic Accounting formulas for personal financesIf you make money, you can increase the cash in your bank account. Yay for assets! Enough cash and you can buy other assets, like stocks or real estate.

But if you are losing money and piling up credit card debt, you are taking on more liabilities. This will decrease your net worth, leaving less “equity” in the first equation.

In other words, you need to maximize your salary/revenue/inflows and minimize your expenses/outflows. You’ll have more net income to add to your assets or pay off your liabilities and thus increase your equity/net worth.

And that’s really the goal of personal finances, right?

6 thoughts on “Two Basic Accounting Formulas Applied to Personal Finances

    1. Thanks for stopping by Lily! The mortgage is still a liability. It’s just offset by the house as an asset. The difference between the value of the house and the outstanding mortgage is your equity.

      The payments you make are an expense. They decrease your cash (asset) but they also decrease your liabilities (not in the same ratio, because of interest and anything in the escrow account – more expenses).

      If it is a rental, making money, the only thing that changes is the additional revenue coming in. But your net income would be higher without having to pay the mortgage.

      The mortgage is not necessarily bad because you probably wouldn’t have the revenue producing property without it. But to get your income higher and be able to translate that income into net worth, you’ll want to reduce the expenses, including the mortgage. 🙂

  1. Personal balance sheets and income statements. That’s what it all comes down to in the end, isn’t it? It seems so simple but how we’ve messed things up. I’ve always tried to buy assets and it has served me well.

    1. It seems so obvious now. But unless you’ve been exposed to accounting or corporate finance, it’s not so obvious. Our education systems don’t do a good job of teaching finances. I always thought if you put all math into dollars and cents maybe students would learn it better. Make algebra all about making money instead of random numbers. Teach math and finance together.

      Ok, time for me to get off the soap box and go to bed. 😆

      Assets good. Liabilities bad. Income good. Expenses bad.

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