accounting

# Common Accounting Equations Every Small Business Owner Should Know

At the core of accounting, there lie equations. This discipline uses various formulas to determine vital financial information of a business. Those who are self-employed or run a small business must sometimes act as an accountant, implementing these standard accounting formulas to procure their needed financial information.

Listed below are 12 of the most basic accounting equations a small business might need for their bookkeeping requirements. This list can be divided into three parts, equations that measure cost analysis, those that calculate profitability, and one formula for measuring cash flow.

Next: Guide to Financial Statements with Templates>>

## Profitability Formulas

The following common accounting formulas can help a business determine their profitability for the accounting period in question. To learn more about the accounting process and corresponding formulas that can help determine the profitability of your company, there are various online bookkeeping courses small business owners can enrol in.

### Contribution Margin

Contribution Margin = Product’s price per unit – Products variable costs per unit

The contribution margin is calculated by the selling price per unit, minus associated variable costs per unit. This accounting formula measures how a specific product contributes to the overall profits of your business.

The contribution margin helps businesses decide whether to sell a specific product at a lower price, and the associated profits created for the company.

### Target Net Income

Target Net Income = Sales – Variable Costs – Fixed Costs

The target net income equation assists business owners in determining their profit goal for a specific accounting period. It will let them know how many sales they need to make to reach their target profit.

### Gross Profit

Gross Profit = Total Sales – Cost of Goods Sold

The gross profit accounting formula determines the percentage of sales exceeding the cost of goods sold. This informs the business how much money they will make on a product once all manufacturing costs associated with the product have been paid.

Sometimes the gross profit is better understood and used in terms of percentage. To find the percentage, a business can take this formula and multiple the number by 100. The same can be done for the following accounting equation to obtain the concurrent percentage.

### Gross Margin

Gross Margin = Net Sales – Cost of Goods Sold

The gross margin of a company refers to their net sales revenue minus its cost of goods sold. In other words, the gross margin equation calculates a business’ retained sales revenue after deducting all costs associated with manufacturing and selling off the products. Again, multiply the final number of gross margin, but 100, to determine the working percentage.

### Net Profit Margin

Net Profit Margin = Net Income ➗ Total Sales Revenue

Calculating the net profit margin will illustrate a company’s revenue that is left over after all expenses have been deducted from its sales. Therefore, the final number will determine how much profit the business obtains from its total sales.

### Retained earnings equation

The retained earnings equation shows how much net income you have left after you’ve paid shareholders their dividends. Having a grasp on this accounting formula can help you grow your business by reinvesting, paying out additional dividends, financing a new product, or even paying off debt. Take a look at the retained earnings equation below:

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

What this accounting equation includes:

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

Knowing how to calculate retained earnings allows owners to perform a more in-depth financial analysis. The statement of retained earnings allows owners to analyze 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 was zero.

## Cost Analysis Equations

The formulas below will help a business analyze the cost of their manufacturing and production and compare numbers for appropriate operations. Small businesses can also use financial calculators to further determine their financial position.

### Assets

Assets = Liabilities – Owner’s Equity

This assets equation, also known as the accounting equation, is one of the most important calculations for a business. It allows a company to determine their total assets, as in everything a company owns, such as cash, accounts receivable, and inventory.

Subtracting liabilities, or the amount of money you must pay out to people such as accounts payable, against the owner’s equity, the amount of the company belonging to the owner, will result in the total amount of assets a company actually owns.

### Break-Even Point

Break-even Point = Fixed Costs ➗ Contribution Margin

Or

Break-Even Point = Fixed Costs ➗ (Sales price per unit – variable costs per unit)

To find the break-even point, you must take the calculation from the contribution margin- sales price per unit minus the variable cost of the unit- and divide that by the fixed costs of production of that product.

Calculating the breakeven point helps your business find the level of production where the costs of producing a product will equal the revenue made by the product.

### Price Variance

Price Variance = (Actual Price – Standard Price) x Actual Quantity

The purpose of the price variance formula is to determine the quantity of products to order for a business within a specified accounting period. The resulting number is a vital part of the budgeting and planning process of any company, as it shows the difference between the actual price of a product versus the budgeted price of said product.

### Efficiency Variance

Efficiency Variance = (Actual Quantity – Budgeted Quantity) x Standard Price

Where the price variance illustrates the difference between the actual price and budget price of a product, the efficiency variance formula determines the difference between the actual and budgeted quantities of the product. This common accounting formula helps businesses with its overall efficiency in the manufacturing process of its products.

### Variable Overhead Variance

The variable overhead variance can be broken into two distinct formulas, one for time efficiency, and one for spending.

Variable Overhead Efficiency Variance =

Standard Overhead Rate x (Actual Hours – Standard Hours)

The variable overhead variance equation allows companies to ascertain the difference between the budgeted time of manufacturing its products versus the actual time it takes to create them. This formula highlights the number of labour hours needed for manufacturing.

Variable Overhead Spending Variance =

(Actual Hours Worked x Actual Variable Overhead Rate) – (Actual Hours Worked x Standard Variable Overhead Rate)

The variable overhead spending variance describes the difference between the budgeted amount for an expense, versus the actual cost of the expense for the company.

### Cost of Goods Sold (COGS)

COGS = Starting Inventory + Purchases during period – Ending Inventory

The cost of goods sold, or COGS, of a company is the overall costs associated with the production and sales of their product within a specified accounting period. The starting Inventory refers to the inventory amount at the beginning of the specified period, while the Ending Inventory is the amount at the close of the period.

The calculated number will be an important aspect of a business’ income statement and will help determine the overall gross profits of that accounting period.

## Cash Flow Equations

### Cash ratio equation

Most businesses take on some form of debt to operate, such as business loans, mortgages, and pension obligations. The cash ratio equation measures your company’s liquidity, or ability to pay off all of these liabilities at once if you were required to do so. Below is the cash ratio 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.

### Acid-Test Ratio

Acid Test Ratio = (Cash + Marketable Securities + Accounts Receivable)

➗ Current Liabilities

The purpose of the acid-test ratio, or quick ratio, is to test the liquidity of the company. Liquidity refers to a company’s ability to liquify their assets in case of an emergency.

In a situation where a company’s liabilities must be paid off right away, this calculation checks its short-term assets against liabilities to ensure coverage of its financial obligations within a specified period.

## Debt Equation

### Debt-to-equity ratio

The debt-to-equity equation is a business formula that shows how much debt a company uses to finance its operations. To understand the stability of your company, the debt-to-equity ratio can prove helpful:

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

What this accounting equation includes:

• Total liabilities include all of the costs you must pay to outside parties, such as accounts payable, balances, 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 shareholders. Suppose you’re attempting to secure more financing or looking for investors. In that case, a high debt-to-equity ratio might make it more difficult to find creditors or investors willing to provide funds for your company.

## Accounting Software Helps with Equations

Quickly calculate must-know accounting and bookkeeping formulas with cloud accounting for small businesses to ensure accuracy for your financial records. Start using QuickBooks Online and gain professional software that can help your business with accounting formulas and more. Why not try it free today!

Next: Guide to Financial Statements with Templates>>

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