11 accounting formulas for small businesses

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.

4. Cash ratio equation

Most businesses use 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 required. 

What this accounting equation includes:

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

Below is the cash ratio equation:

Cash Ratio = Cash ÷ Current Liabilities

5. Profit margin equation

To better understand how your business uses its revenues to generate profits, use the profit margin equation. This accounting formula not only shows the overall health of your company, but it also helps derive a better strategy:

Profit margin = net income ÷ sales

What this accounting equation includes:

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

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 consists 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 take a look at the figures making up your net income.

6. Debt-to-equity ratio equation

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 shareholders and outside parties, such as accounts payable, balances, interest, and principal payments on debt.
• Total equity is the amount of money the owner has invested in the company; the amount of the company that actually belongs to the owners.

A high debt-to-equity ratio illustrates that a large proportion of your company’s financing comes from issuing debt rather than equity 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.

7. Cost of goods sold equation

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:

• 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 remaining product you have at the end of the period.

The cost of goods sold equation allows you to determine how much you spent on manufacturing the goods you sold. You can determine your gross profit by subtracting the costs of goods sold from revenues.

8. Retained earnings equation

The retained earnings equation shows how much net income you have left after you’ve paid shareholders their dividends. 

Retained Earnings = Beginning Retained Earnings + Net Income Or Net Loss - Cash 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.

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 inventory.

Knowing how to calculate retained earnings helps business owners perform a more in-depth financial analysis. The statement of retained earnings also 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.

9. Gross profit equation

The gross profit equation helps determine the profitability of a company's core business activities before considering operating expenses, interest, and taxes. 

Gross profit is an important metric for evaluating your business's financial health. Understanding this formula can help you set pricing, manage production costs, and forecast future revenue.

This is the formula for calculating gross profit:

Gross Profit = (Net Sales - Cost of Goods Sold (COGS))

What this accounting equation includes:

• Net sales represent the total revenue generated from goods or services sold minus returns and discounts.
• Cost of goods sold (COGS) refers to the direct costs associated with producing the goods or services sold, such as materials and labor.

Gross profit reflects the financial success of your products or services by reflecting how much money remains after production costs. It helps you assess whether pricing and cost management strategies are effective.

10. Return on assets (ROA) equation

The return on assets equation measures how efficiently a company is using its assets to generate profit. It's a key metric for evaluating how well management is deploying resources. Knowing your ROA helps identify how profitable your company is relative to the assets it holds, and here's the formula:

Return on assets = net income ÷ average total assets

What this accounting equation includes:

• Net income is the company's profit after all expenses, taxes, and costs have been deducted from revenue.
• Average total assets refers to the average value of all assets a company holds over a given period. It can be calculated by averaging the beginning and ending asset balances for the period.

ROA helps investors and business owners understand how effectively a company is turning its investments in assets into profits.

11. Quick ratio equation

The quick ratio equation, also known as the acid-test ratio, evaluates a company's ability to meet its short-term obligations using its most liquid assets. It’s a conservative measure of liquidity, making it useful for assessing a business’s short-term financial health.

Quick ratio formula:

Quick Ratio = (Current Assets - Inventory) ÷ Current Liabilities

What this accounting equation includes:

• Current assets are assets that can be converted into cash within a year, excluding inventory.
• Current liabilities represent debts or obligations the company must pay off within the same time period.

The quick ratio equation does not include inventory, since it may not be as easily liquidated as other current assets like cash or receivables.

This formula helps assess whether a business can meet its short-term liabilities without relying on the sale of inventory, providing a more stringent measure of liquidity than the current ratio.

Accounting formulas in double-entry accounting

When recording transactions, it's essential to follow the principles of double-entry accounting. This method involves making journal entries by posting debits on the left side and credits on the right side of your ledger, ensuring that every transaction is balanced. The total dollar value of debits must always equal the total dollar value of credits.

Double-entry accounting works in tandem with accounting formulas, particularly the accounting equation, which serves as its foundation. The accounting equations underscore the critical role of double-entry bookkeeping in maintaining accurate financial records and a balanced balance sheet.

What is a balance sheet?

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. 

A balance sheet has three main components: total assets, liabilities, and shareholder's equity. All three work together 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, they’ll be listed as liabilities on your balance sheet. Assets financed by investors and common inventory will be listed as shareholder’s equity on your balance sheet. It can take the form of common inventory, retained earnings, and additional paid-in capital.

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.

Accounting basics for small businesses

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.

Accrual basis accounting method

The accrual basis accounting method recognizes expenses and revenues at the time of a sale.

Cash basis accounting method

The cash basis accounting method recognizes expenses and revenues when a payment is received.

Accounts receivable

Accounts receivable is money owed by customers for a product or service they purchased.

Income statement

The income statement is a financial document that summarizes a business’s income, expenses, and total costs over a specific period to determine its profits or losses.

Cash flow statement

The cash flow statement is a financial document that shows the money coming in and going out of your business accounts.

Generally accepted accounting principles (GAAP)

GAAP is a global standard for financial reporting with a wide array of principles, such as how to recognize expenses and assets, liabilities, and revenue, how to measure and report profits and losses, and how to present information on financial statements.

Using accounting formulas to monitor your company’s financial health

A thorough accounting system and a well-maintained general ledger help accurately assess your company’s financial health. There are many more formulas that you can use, but the 11 we 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 when factoring in the potentially hundreds of accounts they have in their company.

Fortunately, you don’t have to worry about it, as 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 analyze your business’s health.