Introduction
Over its fiscal year ended June 2025, Microsoft's total assets grew by $106.8 billion. Its liabilities and shareholders' equity grew by exactly the same amount, to the dollar: $31.8 billion more liabilities and $75.0 billion more equity. That is not a coincidence of Microsoft's year. It is true of every company, every year, because the balance sheet, one of the three financial statements, is built on an identity known as the accounting equation: assets equal liabilities plus equity.
The equation is often taught as a rule to memorize, but it is better understood as a consequence of how equity is defined. Once that is clear, two practical skills follow: tracing what any transaction does to the balance sheet, and knowing that a financial model whose balance sheet does not balance has an error somewhere, rather than an unusual business.
Why Assets Always Equal Liabilities Plus Equity
The FASB's conceptual framework defines the three elements precisely. In its 2021 chapter on the elements of financial statements, an asset is a present right of an entity to an economic benefit, a liability is a present obligation of an entity to transfer an economic benefit, and equity is the residual interest in the assets that remains after deducting liabilities.
The last definition is what makes the equation hold. Equity is not measured independently; it is whatever is left after liabilities are subtracted from assets. Rearranged, assets equal liabilities plus equity, always, by construction. A company can have more assets than liabilities (positive equity) or fewer (negative equity), but it cannot have a balance sheet on which the two sides differ.
- Accounting equation
The identity on which every balance sheet is built: assets equal liabilities plus shareholders' equity. It holds at every date because equity is defined as the residual interest in the assets after deducting liabilities.
Microsoft's balance sheet at June 30, 2025 shows the identity at both year ends, and shows the changes balancing too:
| Line item | Jun 30, 2024 | Jun 30, 2025 | Change |
|---|---|---|---|
| Total assets | 512,163 | 619,003 | +106,840 |
| Total liabilities | 243,686 | 275,524 | +31,838 |
| Total stockholders' equity | 268,477 | 343,479 | +75,002 |
| Total liabilities and stockholders' equity | 512,163 | 619,003 | +106,840 |
Source: Microsoft fiscal 2025 Form 10-K. Retained earnings rose from 173,144 to 237,731, the largest single part of the increase in equity.
Read from right to left, the equation is also a statement about financing. Every asset a company holds was paid for either with money owed to someone else, such as suppliers, lenders or employees, or with money belonging to the owners, either invested directly or earned and retained. In fiscal 2025, most of Microsoft's new assets were financed by equity, largely profits it kept rather than paid out. A company just acquired in a leveraged buyout looks very different: the same equation holds, but a far larger share of the right-hand side is debt. The mix between the two claims is a basic input when lenders and rating agencies judge risk, and how each side of the balance sheet is organized into current and noncurrent items is covered in how the balance sheet works.
Four Ways a Transaction Can Move the Equation
Because the identity always holds, every transaction must change the balance sheet in a way that keeps it true. Bookkeepers enforce this with double-entry bookkeeping, recording every transaction in at least two accounts, a mechanic bankers rarely need directly, as explained in how much debits and credits matter for bankers. For analysis, it is enough to know that there are only four patterns, and recognizing them makes any transaction easier to trace:
- Asset swap: one asset rises and another falls by the same amount, such as buying equipment for cash. Totals do not change.
- Both sides rise: an asset increases along with a liability or equity, such as borrowing cash or issuing shares.
- Both sides fall: an asset decreases along with a liability or equity, such as repaying a loan or paying a dividend.
- Claims swap: one liability or equity account rises and another falls, such as converting debt into shares. Assets do not change.
Revenue and expenses fit the same scheme through retained earnings, the part of equity that accumulates profits not paid out. Profit increases equity and losses reduce it, so the equation can be written in an expanded form:
The formula leaves aside other equity accounts, such as shares bought back and held in treasury or gains recorded outside net income, but it shows why the income statement and the balance sheet can never drift apart: every dollar of net income ends up in equity, and every dollar of revenue or expense has a matching change elsewhere on the balance sheet. The same logic connects the cash flow statement, whose bottom line must equal the change in the cash asset, as the explainer on linking the three financial statements shows from the modeling side.
- Retained earnings
The cumulative net income a company has earned since inception, less the dividends it has paid. It sits in shareholders' equity and is the account through which profits and losses reach the balance sheet.
A Sale Traced Through the Equation
Consider a company that sells goods for $100 in cash. The goods cost $60 and were already in inventory, and the company pays tax at 25% in cash. The sale touches all three statements, and the balance sheet ends up balanced:
Assets rise by a net $30: cash up $90, inventory down $60. Liabilities do not change, because the tax was paid immediately. Equity rises by the $30 of net income added to retained earnings. Both sides move by $30, which is the equation doing its job. Had the tax been owed rather than paid, cash would have risen by $100, assets by $40, and a $10 tax liability would have appeared alongside the $30 of equity. The step-by-step method behind blocks like this one is laid out in tracing a transaction through the statements.
What the Equation Means for a Banker
The first practical use is the balance check. A three-statement model projects assets, liabilities and equity separately, and because the equation is an identity, any difference between the two sides points to an error: a cash flow that was not linked, a balance that was double-counted, a sign that was flipped. Bankers treat a balance sheet that does not balance as a bug to be found, never as a figure to be plugged, and the common causes are worked through in the balance check.
The second use is reading capital structure. Because equity is a residual, it absorbs everything: profits, losses, dividends, buybacks and write-downs. A company that has bought back more shares than its accumulated profits can show negative shareholders' equity while remaining profitable and creditworthy, because the equation only says the balance sheet balances, not that equity is positive. Lowe's is a real case: its annual report for the year to January 2026 shows a shareholders' deficit of $9.9 billion after a year of $6.7 billion net earnings, the result of years of buybacks charged mostly against retained earnings. Conversely, large losses or impairments can wipe out equity even when the business still generates cash. The pieces of equity, from common stock and additional paid-in capital to treasury stock, are explained in shareholders' equity.
For a banker, the working version of the equation is simple, and it applies to interview questions and live deal work alike. Every time a transaction is described, ask which of the four patterns it follows, find the matching change on the other side of the balance sheet, and check that the two sides moved by the same amount. If they did not, something in the reasoning is missing, and finding it is usually the point of the exercise.
