What do you learn from basic equation of accounting and how

What do you learn from basic equation of accounting and how would this help in project financing. Illustrate with specific examples.

Solution

Q1: What is the basic equation of accounting?

The basic equation of accounting represents the number of assets owned by the company and those assets which are owned by the company are financed from what kind of sources:-

Basic equation of Accounting ( Assets = Liabilities + Shareholder Funds )

(1) Source I: The assets are financed through internal equity i.e. Shareholder funds

(2) Source II: The assets are financed through external equity i.e. liabilities.

Q2: How the basic equation of accounting helps in project financing?

Solution: The basic equation of accounting significantly assist in project financing. It simply tells the number of sources already used by the company or business to finance previous assets or projects.

For an example, if the company has made more use of external equity ( 70% of assets are financed through external equity) i.e. liabilities in the form of bank loan, debentures and public deposits etc to finance the assets then in new project financing, it is not advisable to take more external loan or liability. It will enhance the financial risk of the company i.e. company may not able to pay interest later on to the creditors.

On the contrary, the company have used shareholder funds like equity share finaning and internal reserves of th company etc. In such a case, to finance a new project the company may think of external financing due to less financial risk.