7 business equation everyone should know

By Jo Poucher

4 min read

Managing your business finances and revenues can be a full-time job, and you might even have a full-time accountant employed to handle the books. Many small business owners, however, prefer to handle this aspect of their businesses themselves, foregoing an accountant in order to maintain control over their own books.

If you fall into the latter category, here are some standard accounting formulas you should know. These formulas are generally regarded as universal to any business and will provide you with the figures you need to understand the viability and health of your business.

  1. The accounting equation

Business Equation: (assets = liability + owner’s equity)

What it means: also called the balance sheet equation, this represents the relationship between the assets, liabilities, and owner’s equity of a business:

  • Assets are all of the things your company owns, including property, cash, inventory and equipment that will provide you with a future benefit.
  • Liabilities are obligations that you must pay, including things like lease payments, merchant account fees and debt.
  • Owner’s equity is the portion of the company that actually belongs to the owner.
  1. Net income

Business Equation: (net income = revenues – expenses)

What it means: the money that you have earned at the end of the day:

  • Revenues are the sales or other positive cash inflows that come into your company.
  • Expenses are the costs that are associated with making sales.
  • By subtracting your revenue from your expenses, you can calculate your net income. It’s possible that this number will be negative when your business is in its early stage, so the goal is for your net income to become positive, meaning your business is profitable.
  1. Break-even point

Business Equation: (break-even point = fixed costs / sales price – variable cost per unit)

What it means: how much you need to sell in order to cover all of your costs:

  • Fixed costs are recurring, predictable costs that you must pay in order to conduct business. These costs include insurance premiums, rent, employee salaries, etc.
  • Sales price is the retail price you sell your products or services for.
  • Variable cost per unit is the amount it costs you to make your product.
  • If you divide your fixed costs by the sale price of your product, minus the amount it costs to make your product, you’ll have your break-even point.
  1. Cash ratio

Business Equation: (cash ratio = cash / current liabilities)

What it means: this ratio demonstrates how well your business can pay off its current liabilities:

  • Cash is simply the amount of cash you have at your disposal. This can include actual cash and cash equivalents (i.e. highly liquid investment securities).
  • Current Liabilities are the current debts the business has incurred.
  • The higher the number, the healthier your company.
  1. Profit margin

Business Equation: (profit margin = net income / sales)

What it means: how profitable your business is:

  • Net Income is the total amount of money your business has made after expenses have been deducted.
  • Sales is the total amount of sales you’ve generated.
  • When you divide your net income by your sales, you’ll get your organisation’s profit margin. A high profit margin indicates a very healthy company. A low profit margin can reveal how unsuccessful a company might be, but it can also mean that your organisation doesn’t handle its 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 your expenses.
  1. Debt-to-equity ratio

Business Equation: (debt-to-equity ratio = total liabilities / total equity)

What it means: how much of your financing comes from outside sources:

  • Total liabilities includes all of the costs you must pay to outside parties, such as loan or interest payments.
  • Total equity is how much of the company actually belongs to the owner or other employees. 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 outside sources, such as banks. If you’re attempting to secure more financing or looking for investors, a high debt-to-equity ratio might make it more difficult to secure funding.
  1. Cost of goods sold

Business Equation: (cost of goods sold = cost of materials/inventory – cost of outputs)

 

What it means: how much it costs you to make your product:

 

  • Cost of materials/inventory is the amount of money your company has to spend to secure the necessary products or materials to manufacture your product.
  • Cost of outputs is the total cost of the goods sold.
  • By subtracting the cost of outputs from the cost of materials, you’ll know your cost of goods sold. This tells you if the costs you’re paying to make your product are in line with the revenue you earn when you sell it.

 

There are many more accounting formulas that you can use, but these seven are some of the more common. It’s best to have a good grasp of these formulas even if you’re not planning to manage your own accounting. The more knowledge you have regarding your finances, the better you can manage your business.

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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