8 accounting equations every business owner should know

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

However, many small businesses—especially new small businesses —prefer to handle this aspect of their businesses themselves, 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 can apply to a wide array of businesses. Combined with an understanding of accounting basics for small businesses, the accounting formulas will provide you with the figures you need 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 fuller understanding of accounting formulas or use the list to jump to an accounting equation of your choice.

  1. Accounting equation
  2. Net income equation
  3. Break-even point equation
  4. Cash ratio equation
  5. Profit margin equation
  6. Debt-to-equity ratio equation
  7. Cost of goods sold equation
  8. Retained earnings equation

What is the accounting equation?

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 of the basic accounting equations discussed throughout this post stress the importance of double-entry bookkeeping.

What is the balance sheet?

balance sheet is a financial document that shows what a company owns and owes, along with the equity that shareholders have 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: assets, liabilities, and shareholder’s equity. All three work in tandem to show a company’s financial position.

  • Assets are what your business owns and are resources used to produce revenue. Current assets are short-term assets like cash and stock inventory, while fixed assets are long-term assets like equipment and land.
  • Liabilities are what your business owes, such as accounts payable, short-term debts, and long-term debts.
  • Shareholder’s equity, also called owner’s equity, is the difference between assets and liabilities and can be looked at as the true value of your company. Shareholder’s equity can take the form of common stock, retained earnings, and additional paid-in capital.

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 stock will be listed as shareholder’s equity on your balance sheet.

Accounting equations balance sheet graphic

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: Accounting method in which a company recognizes expenses and revenues at the time of a sale
  • Cash basis accounting method: Accounting method in which a company recognizes expenses and revenues when a payment is received
  • Accounts receivable: Money owed by customers for a product or service they purchased
  • Income statement: Financial document that summarizes a business’s income, expenses, and total cost during a specific period to determine the profit or losses during this period
  • Cash flow statement: Financial document that shows the money coming in and going out of your business accounts
  • Generally accepted accounting principles (GAAP): American standard for financial reporting with a wide array of principles, such as how to recognize expenses, assets, liabilities, and revenue; how to measure and report profits and losses; and how to present information on financial statements

Accounting formulas for businesses

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 analyzing total sales. Below are some of the most common accounting equations businesses should know.

1. Accounting equation

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?

Accounting equations: total assets equals liabilities plus 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 it must pay, including things like lease payments, merchant account 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 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 liabilities and equity on the right side of the equation.

2. Net income equation

As a business owner, you need 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:

  • Revenues are the sales or other positive cash inflow that come 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 equation

Business owners have many expenses to keep their company running. Salaries, materials, rent—these are just some of the costs you will be responsible for. 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:

  • Fixed costs are recurring, predictable costs that you must pay to conduct business. These costs can include insurance premiums, rent, employee salaries, etc.
  • Sales are the sales prices 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 $0. Every sale over the break-even point will generate a profit.

4. 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.
Accounting equations cash ratio

5. Profit margin equation

If you want to know how well your business uses its revenues to generate a profit, use the profit margin equation. This accounting formula shows the overall health of your company:

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 organization’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. A low profit margin could suggest 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 take a look at the figures making up your net income.

6. Debt-to-equity ratio equation

Small business owner doing accounting equations at home on computer

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.

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 product you have remaining 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. By subtracting the costs of goods sold from revenues, you’ll determine your gross profit.

8. 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.

Using accounting formulas to monitor your company’s financial health

A thorough accounting system and a well-maintained general ledger allow you to assess your company’s financial health accurately. 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, 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,  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 analyze your business’s health. The more knowledge you have regarding your finances, the more efficiently you can run your business.

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