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Running a business

Eight accounting equations every business should know

Managing your business’s finances and revenue can be a full-time job, so much so that you may need to create a financial position to handle these duties within your small business.

However, many small businesses—especially businesses just getting started—prefer to handle this aspect of their business themselves, thus foregoing the help of an accountant to manage the company’s balance sheet and business transactions.

If you’re a small business owner who would prefer to monitor your company’s cash flow with your own two eyes, there are financial accounting equations that you should be familiar with. These fundamental accounting equations are rather broad, meaning they should apply to various types of businesses. Combined with a basic understanding of how accounting works, the equations will provide you with the figures you need to understand the viability and health of your business and to make more informed business decisions.

Whenever you post a transaction, you should practice double-entry accounting. Double-entry accounting requires you to post debits on the left side and credits on the right side of a ledger. The total dollar amount of debits and credits always needs to balance. All of the following equations stress the importance of double-entry bookkeeping.

1. Overall value

The equation:

Total assets = liabilities + equity

What this accounting equation includes:

  • Assets are all of the things your company owns, including property, cash, inventory, accounts receivable and any equipment that will allow you to produce a future benefit.
  • Liabilities are obligations that the company must pay, including things like lease payments, merchant service fees, accounts payable and any other debt service.
  • Equity is the portion of the company that actually belongs to the owner. If shareholders own the company, then the stockholders’ equity would fall into this category as well.

This is a balance sheet equation. The dollar amount of assets on the left side of the equation must equal the sum of the liabilities and equity on the right side of the equation.

2. Net income

The equation:

Net income = revenue – expenses

What this accounting equation includes:

  • Revenue is the sales or other positive cash inflow that comes into your company.
  • Expenses are the costs incurred to generate revenue.

By subtracting your revenue from your expenses, you can calculate your net income. This is the money that you have earned at the end of the day. It’s possible that this number will demonstrate a net loss when your business is in its early stages. The ultimate goal of any business should be positive net income, which means your business is profitable.

3. Break-even point

The equation:

Break-even point = (sales – fixed costs – variable costs = $xx.xx profit)

What this accounting equation includes:

  • Fixed costs are recurring, predictable costs that you must pay to conduct business. These costs can include insurance premiums, rent, employees’ salaries, etc.
  • Sales is the sales price charged multiplied by the number of units sold.
  • Variable costs are any costs you incur that change based on the number of units produced or sold.

The break-even point tells you how much you need to sell to cover all of your costs and generate a profit of $xx.xx. Every sale over the break-even point will generate a profit.

4. Cash ratio

The equation:

Cash ratio = cash ÷ current liabilities

What this accounting equation includes:

  • Cash is the amount of cash you have at your disposal. This can include actual cash and cash equivalents, such as highly liquid investment securities.
  • Current liabilities are the current debts the business has incurred.

This ratio gives you an idea of how much cash you currently have on hand. It also demonstrates how well your business can pay off its current liabilities. The higher the number, the healthier your company.

5. Profit margin

The equation:

Profit margin = net income ÷ sales

What this accounting equation includes:

  • Net income is the total amount of money your business has made after removing the expenses.
  • Sales refers to the operating revenue you generate from business activities.

When you divide your net income by your sales, you’ll get your organisation’s profit margin. Your profit margin reports the net income earned on each dollar of sales. A high profit margin indicates a very healthy company, whereas a low profit margin could indicate that your business does not handle expenses well.

Remember that your net income is made up of your total revenue minus your expenses. If you have high sales revenue but still have a low profit margin, it might be time to look at the figures making up your net income.

6. Debt-to-equity ratio

The equation:

Debt-to-equity ratio = total liabilities ÷ total equity

What this accounting equation includes:

  • Total liabilities include all the costs you must pay to outside parties, such as accounts payable balances and interest, and principal payments on debt.
  • Total equity is how much of the company actually belongs to the owners. 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 issuing debt, rather than issuing stock to the shareholders. If you’re attempting to secure more financing or looking for investors, a high debt-to-equity ratio might make it more difficult to find creditors or investors who are willing to provide funds for your company.

7. Cost of goods sold

The equation:

Cost of goods sold = beginning inventory + cost of purchasing new

inventory – ending inventory

What this accounting equation includes:

  • Beginning inventory is how much inventory you have on hand at the beginning of the period.
  • Cost of purchasing new inventory is the amount of money your company has to spend to secure the necessary products or materials to manufacture your products.
  • Ending inventory is the product you have remaining at the end of the period.

The cost of goods sold equation allows you to determine how much you spent to manufacture the goods you sold. By subtracting the cost of goods sold from the revenue, you can determine your gross profit.

8. Retained earnings equation

The equation:

Retained earnings = beginning retained earnings + net income or net loss – cash dividends

What the retained earnings formula includes:

  • Retained earnings represent the sum of all net income since the business’s inception minus all cash dividends paid since the inception.
  • Beginning retained earnings are the retained earnings balance from the prior accounting period.
  • The company’s net income represents the balance after subtracting the expenses from the revenue. It’s also possible for this to result in a net loss.
  • Cash dividends are cash payouts to those who own ordinary shares.

Knowing how to calculate retained earnings allows owners to perform a more in-depth financial analysis. The statement of retained earnings allows owners to analyse net income after accounting for dividend payouts. Owners should calculate the statement of retained earnings at the end of each accounting period even if the amount of dividends issued is zero.

Monitor your company’s financial health

A thorough accounting system and a well-maintained general ledger allow you to properly assess the financial health of your company. There are many more formulas that you can use, but the eight that we provided are some of the most important.

Although these equations seem straightforward, in reality, they can become more complicated. Many small business owners find it very challenging to balance the right side of the equation with the left side of the equation when factoring in the potentially hundreds of accounts they have in their company.

Fortunately, small business accounting software can help. All you need to do is enter your business transactions. Your accounting software will then crunch the numbers so that you can analyse your business’s health. The more knowledge you have regarding your finances, the more efficiently you can run your business.

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