Keeping track of the revenues and finances of your small or big business is surely a full time job, so you may need to create a financial position to handle these duties within your business.
However, many small businesses—especially new businesses —prefer to handle this aspect of their businesses themselves, forgoing the help of an accountant to manage the balance sheet, business transactions, cash flow statement, and financial statements
If you’re a small business owner who would prefer to monitor your company’s cash flow statement with your own two eyes, there are financial accounting formulas that you should be familiar with. These basic l accounting equations are rather broad, meaning they can apply to a variety of businesses. Combined with an understanding of accounting basics for small businesses, the accounting formulas will provide you with the figures needed to understand your business’s viability and health to make more informed business decisions.
Below, we’ll cover the fundamentals of the accounting equation and the top business formulas businesses should know. Read end-to-end for a thorough understanding of accounting formulas or use the list to jump to an equation of your choice.
Whenever you post a transaction, you should practice double-entry accounting. Double-entry accounting requires you to make journal entries by posting debits on the left side and credits on the right side of a ledger in your balance sheet. The total dollar amount of debits and credits always needs to balance.
To perform double-entry accounting, you use the accounting equation, also called the balance sheet formula, to ensure your company’s assets equal the sum of your company’s liabilities and shareholder’s equity. The accounting balance sheet formula makes sure your balance sheet stays balanced.
All basic accounting formulas discussed throughout this post highlight the importance of double-entry bookkeeping.
A balance sheet is a financial document that shows what a company owns and owes, along with shareholder equity in a company. The balance sheet is used to provide a picture of how a company is performing at a specific moment in time. There are three main components to a balance sheet: total assets, liabilities, and shareholder’s equity. All three work in tandem to show a company’s financial position.
On your balance sheet, these three components will show how your business is financially operating. Your assets include your valuable resources, while your liabilities include any debts or obligations you owe. If your assets are financed by debt, it’ll be listed as a liability on your balance sheet. Assets financed by investors and common Inventory will be listed as shareholder’s equity on your balance sheet.
With the accounting equation, you can better manage your business’s finances and evaluate your business transactions to determine whether they’re accurately reported. If both ledgers of your balance sheet don’t match, there may be an error.
As a small business owner, you need to understand a few key accounting basics to ensure your company operates smoothly. Below, we’ll cover several accounting terms and principles you should have a firm grasp on. For a complete list, refer to our full lists of accounting terms and accounting principles.
There are a variety of accounting formulas for businesses that can be used for a variety of purposes, such as producing a statement of cash flows, reviewing inventory turnover, and analysing total sales. Below are some of the most common accounting equations businesses should know.
As stated, the accounting equation or balance sheet equation is one of the most important accounting formulas you should know. So, what is the balance sheet equation?
What this accounting equation includes:
This is a balance sheet equation. The dollar amount of assets on the left side of the equation must equal the sum of liabilities and equity on the right side of the equation.
As a business owner, it is important to know whether your company is profitable or not, especially if you’re looking for investors. One business equation an investor may use is the net income equation:
Net income = revenues – expenses
What this accounting equation includes:
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, meaning that the business is profitable.
Business owners have many expenses to keep their company running, including salaries, logistical costs, and rents—these are just some of the costs you will be responsible for. However, If you’re not breaking even, your business can land in troubled waters. The break-even point equation is an important business formula that can help you determine whether you can cover your costs or make a profit. The following is the break-even point equation:
Break-even point = (sales – fixed costs – variable costs = $0 profit)
What this accounting equation includes:
The break-even point tells you how much you need to sell to cover all of your costs and generate a profit of $0. Every sale over the break-even point will generate a profit.
Most businesses take on some form of credit 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:
To get a better understanding of how your business uses its revenues to generate profits, use the profit margin equation. Not only this accounting formula shows the overall health of your company, but also helps derive a better strategy:
Profit margin = net income ÷ sales
What this accounting equation includes:
When you divide your net income by your sales, you’ll get your business'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, while a low profit margin could suggest that the business does not handle expenses well.
Remember,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 a high time to take a look at the figures making up your net income.
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:
A high debt-to-equity ratio illustrates that a high proportion of your company’s financing comes from issuing debt, rather than issuing Inventory 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.
Knowing how much it costs to create the products you sell is important, as it shows how efficiently you create your products. The cost of goods sold formula helps you determine this information:
Cost of goods sold = beginning inventory + cost of purchasing new inventory – ending inventory
What this accounting equation includes:
The cost of goods sold equation allows you to determine how much you spent on manufacturing the goods you sold. By simply subtracting the costs of goods sold from revenues, you’ll determine your gross profit.
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 credit or debt. Take a look at the retained earnings formula below:
Retained earnings = beginning retained earnings + net income or net loss – cash dividends
What this accounting equation includes:
Knowing how to calculate retained earnings helps business owners to perform a more in-depth financial analysis. Also, 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 was zero.
A thorough accounting system and a well-maintained general ledger helps assess your company’s financial health accurately. There are many more formulas that you can use, but these eight covered in this article are undoubtedly key for a profitable business.
Although these equations seem straightforward, they can become more complicated in reality. Many small business owners find it much more 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, you don’t have to worry about it as 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 and make profit
