Managing your business’s finances and revenues 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 business just getting started—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 should apply to an array 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 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
The equation:
Net Income = Revenues – Expenses
What this accounting equation includes:
- Revenues are 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 = $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 is 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
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 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 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 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 take a 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 of 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 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 costs of goods sold equation allows you to determine how much you spent to manufacturer the goods you sold. By subtracting the costs of goods sold from revenues, you’ll 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 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 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 issues was 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, 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.