Maintaining a clear picture of financial performance is crucial for businesses of all sizes. Businesses worldwide utilize practical and accessible accounting formulas to oversee cash flow statements, handle business transactions, and generate balance sheets and financial statements.
A Guided Journey Through Essential Accounting
Feeling apprehensive? Rest assured, you won’t need to memorize countless accounting formulas as in your academic days. When dealing with business accounting, a select few formulas prove more than sufficient. In this article, we’ll explore six such accounting formulas that you simply mustn’t overlook for efficient business accounting management.
Let’s dive in!
1. The Balance Sheet Equation This fundamental accounting equation is as useful today as ever in business accounting. It defines how a balance sheet achieves balance. The equation is:
Assets = Liabilities + Equity
Where:
Assets represent what you own, liabilities are what you owe, and equity refers to retained earnings or contributions to the business.
Understanding this equation offers insight into your business’s financial ‘health.’ For instance, consider that your total bank balance, physical assets (like furniture, computers), and accounts receivable amount to $20,000 – your assets.
If your total liabilities (credit cards, accounts payable, lines of credit, etc.) amount to $10,000, your equity (the total of unclaimed contributions and profits) will equal assets minus liabilities ($20,000 – $10,000), which equals $10,000. This calculation demonstrates the likely health and profitability of your business, suggesting you’re not over-utilizing resources to maintain operations.
2. Net Income Net income, or the bottom line, offers a valuable measure of your business’s profitability. The equation is:
Income – Expenses = Net Income
While revealing profitability, this formula doesn’t account for total bank cash or balance sheet debts (liability payments), nor does it consider capital contributions, asset acquisition, draws, and distributions.
Read More: How to read financial statements
3. Current Ratio Also known as the acid-test ratio, this formula illustrates your ability to meet short-term debts:
Current Assets / Current Liabilities = Current Ratio
If your business has total assets of $15,000, of which $8,000 are current assets (cash or assets quickly converted to cash), and your liabilities amount to $5,000, with $2,000 being current liabilities (debts due within 12 months), your current ratio would be 4. This indicates your capacity to cover short-term debts four times over before depleting cash reserves. An ideal current ratio is more than 1 but not excessively high, which may indicate inefficient capital management, potentially hindering growth.
4. Cost of Goods Sold (COGS) This formula provides the cost to create the products you sell, reflecting your production efficiency:
Beginning Inventory + New Inventory Purchase Cost – Ending Inventory = COGS
For example, if you start with an inventory worth $20,000, spend $10,000 on new inventory, and end with inventory valued at $16,000, your COGS would be $14,000.
5. Gross Profit and Gross Profit Margin Your business’s gross profit equals total sales income minus COGS:
Sales – COGS = Gross Profit
With your COGS at $14,000 and total sales income of $21,000, your gross profit calculates to $7,000.
Gross Profit / Sales = Gross Profit Margin
In this case, your gross profit margin is 33%, signifying that increasing gross profit boosts the gross profit margin and impacts net income. By reducing the cost of sales, you can grow business profitability even without a sales increase.
6. Break-Even Point This formula may be slightly complex but is crucial for your business. It identifies the quantity of product/service you must sell to cover your operating costs, i.e., where total sales equal total expenses:
Break-Even Point = Fixed Costs / (Sales Price Per Unit – Variable Cost Per Unit)
Using an example where operating costs (utilities, payroll, rent) total $6,000/month, the selling price per unit is $3, and COGS is $2 per unit, your break-even point would be 6,000 units. To calculate the break-even point in dollars, multiply the unit sales price by the break-even point in units ($3 x 6,000 = $18,000).
Understanding your break-even point is crucial; after surpassing this point, you start earning profits.
In Conclusion
A comprehensive accounting system and well-maintained general ledger are essential for accurately assessing your business’s financial health. While many accounting formulas exist, the ones mentioned above are crucial.
Though these equations may appear simple, they can prove complex in practice, as balancing the equations while managing numerous company accounts can be challenging.
Accounting software can simplify this process, requiring only the input of business transactions. The software handles the calculations, facilitating analysis of your business health and helping streamline your accounting operations for more efficient business management.