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Seven accounting formulas every business should know


Managing your business finances and revenues can be a full-time job, and you might even have a full-time accountant employed to handle the books. Many small business owners, however, prefer to handle this aspect of their businesses themselves, foregoing an accountant in order to maintain control over their own books.

If you fall into the latter category, below are some standard accounting formulas you should know. These formulas are generally regarded as universal to any business and will provide you with the figures you need to understand the viability and health of your business.

The balance sheet equation

Equation: (assets = liability + owner’s equity)

What it means: This is the key accounting model for the measurement of value and income, representing the relationship between the assets, liabilities, and the owner’s equity of a business.
• Assets are all of the things your company owns, including property, cash, inventory and equipment that will provide you with a future benefit.

• Liabilities are obligations that you must pay, including things like lease payments, merchant account fees and debt.
• Owner’s equity is the portion of the company that actually belongs to the owner.

Net income

Equation: (net income = revenues – expenses)

What it means: This is the money that you have earned at the end of the day.
• Revenues are the sales or other positive cash inflows that come into your company.
• Expenses are the costs that are associated with making sales.
• By subtracting your revenue from your expenses, you can calculate your net income. It’s possible that this number will be negative when your business is in its early stage, so the goal is for your net income to become positive, meaning your business is profitable.
• It’s worth saying that if your business is in the early days, we highly recommend you forecast your monthly sales & expenses for a minimum of the first 18 months, 3 years ideally.  It will give you insight into when you will become profitable and if you’re aware of this, you can make changes to bring this forward if needed. 
• Also, “expenses” includes the cost of procuring or making the goods you are selling. 

Break-even point

Equation: (break-even point = fixed costs / sales price – variable cost per unit)

What it means: This is how much you need to sell in order to cover all of your costs.
• Fixed costs are recurring, predictable costs that you must pay in order to conduct business. These costs include insurance premiums, rent, employee salaries, etc.
• Sales price is the retail price you sell your products or services for.

• Variable cost per unit is the amount it costs you to make your product.
• If you divide your fixed costs by the sale price of your product, minus the amount it costs to make your product, you’ll have your break-even point.

Cash ratio

Equation: (cash ratio = cash / current liabilities)

What it means: This ratio demonstrates how well your business can pay off its current liabilities.
• Cash is simply the amount of cash you have at your disposal. This can include actual cash and cash equivalents (i.e. highly liquid investment securities).
• Current Liabilities are the current debts the business has incurred.
• The higher the number, the healthier your company.

Profit margin

Equation: (profit margin = net income / sales)

What it means: This shows the overall profitability of your business.
• Net Income is the total amount of money your business has made after expenses have been deducted.
• Sales is the total amount of sales you’ve generated.

• When you divide your net income by your sales, you’ll get your business’ profit margin. A high profit margin indicates a very healthy company. A low profit margin can reveal how unsuccessful a company might be, but it can also mean that expenses are not handled well. Remember that net income is made up of total revenue minus all expenses. If you have high sales revenue, but still have a low profit margin, it might be time to take a look at your expenses.

Debt-to-equity ratio

Equation: (debt-to-equity ratio = total liabilities / total equity)

What it means: This highlights how much of your financing comes from outside sources.
• Total liabilities includes all of the costs you must pay to outside parties, such as loan or interest payments.
• Total equity is how much of the company actually belongs to the owner or other employees. In other words, it’s the amount of money the owner has invested in his or her own company.
• A high debt-to-equity ratio illustrates that a high proportion of your company’s financing comes from outside sources, such as banks. If you’re attempting to secure more financing or looking for investors, a high debt-to-equity ratio might make it more difficult to secure funding.

Cost of goods sold

Equation: (cost of goods sold = cost of materials/inventory – cost of outputs)

What it means: This showcases how much it costs you to make your product.
• Cost of materials/inventory is the amount of money your company has to spend to secure the necessary products or materials to manufacture your product.
• Cost of outputs is the total cost of the goods sold.

• By subtracting the cost of outputs from the cost of materials, you’ll know your cost of goods sold. This tells you if the costs you’re paying to make your product are in line with the revenue you earn when you sell it.

There are many more accounting formulas that you can use, but these seven are some of the more common. It’s best to have a good grasp of these formulas even if you’re not planning to manage your own accounting. The more knowledge you have regarding your finances, the better you can manage your business.

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