11 accounting formulas for small businesses

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 ones—often choose to manage their own balance sheets, track expenses and other business transactions, and handle cash flow and financial statements, opting to forgo hiring an accountant.  

If you're taking on this responsibility yourself, it's essential to understand the key accounting formulas. These formulas help you maintain accurate records, evaluate your business's financial health, and make informed decisions for growth and sustainability. 

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 equation and other formulas discussed in this post underscore the critical role of double-entry bookkeeping in maintaining accurate financial records and a balanced balance sheet.

Below, we’ll cover the fundamentals of the accounting equation and the top business formulas that businesses should know. Use the list to jump to an equation of your choice.

• What is the accounting equation?
• What is the balance sheet?
• Accounting basics for small businesses
• Net income equation
• Break-even point equation
• Cash ratio equation
• Profit margin equation
• Debt-to-equity ratio equation
• Cost of goods sold equation
• Retained earnings equation
• Gross profit equation
• Return on assets (ROA) equation
• Quick ratio equation
• Using accounting formulas to monitor your company’s financial health

What is the accounting equation?

The accounting equation represents the basis of double-entry accounting by showing that a company's resources (assets) are funded by its debts (liabilities) and owners' investments (equity).

Also known as the balance sheet equation, it is one of the most important accounting formulas you should understand. It is expressed as follows: 

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 a business 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.

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.

How the accounting equation works

The accounting equation works by ensuring that every financial transaction affects at least two accounts, keeping assets equal to the sum of liabilities and equity. 

• If a company borrows money, assets (cash) increase, and liabilities (loans payable) increase by the same amount.
• If the company earns revenue, assets (cash or accounts receivable) increase, and equity (retained earnings) increases.
• When expenses are paid, assets (cash) decrease, and equity (retained earnings) decreases.

The accounting equation ensures accurate and reliable financial data by keeping assets equal to the sum of liabilities and equity.

Why is the accounting equation important?

The accounting equation is fundamental for understanding a business's financial position and maintaining accurate financial records. It is used to verify the accuracy of bookkeeping entries.

It’s a reflection of a company’s financial health 

The equation illustrates the relationship between assets, liabilities, and equity, providing a snapshot of a company's financial position. It helps determine whether the company owns more than it owes or relies too much on debt.

Supports accurate financial statements

The accounting equation supports the balance sheet, ensuring it remains balanced after every transaction. This consistency allows stakeholders, such as investors and creditors, to trust the financial statements provided.

Helps track growth and debt

It allows businesses to monitor changes in assets, debts, and owner’s equity, making it easier to assess how a company grows or accumulates debt over time.

Prevents errors

For every debit, there is an equal credit. This prevents errors and discrepancies in financial records, enhancing accuracy and reliability.

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. 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.

• Assets are resources owned and used by the business to produce revenue. For a better understanding, it can be divided into two categories: current and fixed assets. The former is short-term and includes assets like cash and stock inventory, while the former long-term that include 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 inventory, 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 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.

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 cost during a specific period to determine the profits or losses during this period.

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, assets, liabilities, and revenue, how to measure and report profits and losses, and how to present information on financial statements.

10 other accounting formulas for businesses

Beyond the accounting equation, numerous accounting formulas serve various purposes, such as preparing a statement of cash flows, evaluating inventory turnover, and analyzing total sales. Below are some of the other most essential accounting formulas every business should understand.

1. Net income 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:

• 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, meaning that the business is profitable.

2. Break-even point equation

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 end up 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 = (fixed costs ÷ contribution margin)

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, bills, 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.

3. Cash ratio equation

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:

• 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.

4. Profit margin equation

To get a better understanding of 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 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.

5. 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 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/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 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.

6. 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. By simply subtracting the costs of goods sold from revenues, you’ll determine your gross profit.

7. 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 credit or debt.

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 inventory.

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 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.

8. 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 shows the financial success of your products or services by reflecting how much money remains after production costs, helping you assess if pricing and cost management strategies are effective.

9. 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.

ROA 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.

10. 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.

The quick ratio 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.

Using accounting formulas to monitor your company’s financial health

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 the 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 analyze your business’s health. The more knowledge you have regarding your finances, the more efficiently you can run your business and make profit.