Key Accounting Formulas Every Small Business Owner Should Know
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For the average business owner, do-it-yourself accounting can be overwhelming. There’s the jargon to decipher and the pressure to get it right. Add in any math anxieties and you might want to quit altogether.
Grasping accounting basics is a must for business owners to accurately gauge their companies’ performance — and it starts with understanding accounting formulas. These make up your financial statement, allow you to plan for the future and help you to improve and anticipate problems, said Sallie Mullins Thompson, a New York-based CPA financial planner and tax strategist who works with small businesses. Without this, businesses are “operating in the dark,” she said.
Still, it’s not uncommon for some business owners to ignore what goes into their companies’ revenue and expenses. More than 40 percent of small business owners consider themselves financially illiterate, according to a 2014 Intuit study.
For instance, Thompson knew the owners of a veterinary practice who didn’t track the company’s income, revenue, debts, accounts receivable, expenses, checking account balance or equipment loan status. The company had 250 employees and multiple locations. “Isn’t that unbelievable for that big of a business?” she said. “They are not proactively managing their business for growth and success.”
Important accounting formulas
To avoid being what Thompson calls “an accidental business owner,” entrepreneurs can familiarize themselves with these basic accounting formulas that make financial statements simple to follow. They are broken down by balance sheet, income statement and other formulas.
These formulas are used to create a balance sheet, which gives you a picture — at a single point in time — of your business’ assets, liability and net worth.
The accounting equation.
The accounting equation is a vital formula and serves as the root of accounting. This is the basic formula.
Net worth = assets – liabilities
For example: If your assets total $100,000 and liabilities are $50,000, your business’ net worth equals $50,000
Current assets are the sum of assets that will convert into cash in less than 12 months.
Current assets = cash + accounts receivable + inventory + prepaid expenses
Accounts Receivable $10,000
Prepaid expenses $10,000
Total current assets $50,000
Net fixed assets:
Net fixed assets represent the book value of fixed assets, such as equipment, furniture and fixtures — after taking into account depreciation.
Net fixed assets = fixed assets @ cost – accumulated depreciation*
Total Fixed Assets
Furniture & fixtures $5,000
Accumulated depreciation ($2,500)
Net fixed assets $12,500
Total assets $62,500
*You can calculate accumulated depreciation by subtracting an equipment’s residual value from its purchase price and dividing that number by the equipment’s expected useful life, according to Corporate Finance Institute.
Here’s what the formula looks like:
Accumulated depreciation = (purchase price – residual value)/expected useful life
The sum of all assets.
Total Assets = Current Assets + Other Assets + Net Fixed Assets
These are long-term assets that include cash, securities, receivables, inventory and prepaid assets, and can be convertible into cash within one year.
Net fixed assets.
This is the purchase price of fixed assets listed on a balance sheet.
Bills due within 12 months of the balance sheet date.
Current liabilities = accounts payable + accrued expenses + current portion of debt + income taxes payable
These expenses include wages, utilities charges and taxes that are incurred periodically and recognized in the books before they are paid for.
Current portion of debt.
This is the company’s liabilities or obligations, such as bills to creditors and suppliers within one year. They appear on the company’s balance sheet and include short-term debt, accounts payable, accrued liabilities and other debts, according to Investopedia.
Income taxes payable.
This is the amount of money your company owes to the government. It appears in the current liabilities section of a balance sheet, according to Investopedia.
Accounts payable = 5,000
Accrued expenses = 7,500
Current portion debt = 3,500
Income taxes payable = 1,500
Total current liabilities = 17,500
Long-term debt = 15,000
Total liabilities = 32,500
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Shareholder’s equity is the value of the company to its owners. It is also called net worth.
Shareholder’s equity = capital stock + retained earnings
Total liabilities & equity.
This is the total obligation plus the entity’s net worth.
Total liabilities & equity = current liabilities + long-term debt + shareholders’ equity
Also known as a profit and loss statement, the income statement reports a company’s financial performance over a specific time period. Unlike a balance sheet, It provides details about a company’s performance over time rather than at a particular moment.
Cost of goods sold (COGS).
These include costs that are necessary to generate the revenues, such as inventory purchases, materials, supplies, commissions, overhead, storage and labor.
COGS = beginning inventory + purchases during the period – ending Inventory
This is the amount left after you subtract the cost of goods sold from net sales.
Gross margin = net sales – cost of goods sold
This is the profit a company makes after deducting the costs associated with making and selling its products or the costs associated with providing its services. Gross profit will appear on a company’s income statement, and you can calculate it with this formula:
Gross profit = revenue – cost of goods sold. If revenues are $100,000 and costs of goods sold are $25,000, the gross profit equals $75,000.
Gross profit margin.
This is a company’s total revenue minus its cost of goods sold (COGS), divided by total revenue, expressed as a percentage. The gross profit margin represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services it sells. The higher the percentage, the more the company retains on each dollar of sales, which it can use to service its other costs and debt obligations. The formula is:
Revenue-COGS/revenue. If you use the same figures as above, 75 percent is the gross profit margin.
This is the sum of expenses for developing and selling the product or service.
Operating expenses = sales & marketing + research & development + general & administrative
Income from operations.
This represents net profit from the product or services sold.
Income from operations = gross margin – operating expenses
Net income is all income minus total expenses — including depreciation, taxes and interest. If the entity’s revenues are $100,000 and the total expenses are $75,000, the net income equals $25,000.
Net income = income from operations + interest income – income taxes
Current ratio or acid test ratio (liquidity).
The current ratio answers the question, “Can the current assets pay off the current liabilities?” The answer is yes if this ratio is equal to or above 1, but a value of 2 is the target because it will provide some cushion. The formula is:
Current assets/liabilities: The ratio for above figures = 2.
The quick ratio.
This is a conservative way of determining if there is enough cash and receivable to pay bills due in next 12 months.
Cash + receivables/current liabilities and value should be at least 1.
Example: If cash + receivables = $75,000 and liabilities are $50,000, the result is 1.5, which is acceptable.
This establishes the amount of revenue or product units you need to sell to cover the fixed/variable costs associated with making the sale. It determines when/if a product or service is profitable.
Break-even point = fixed costs/sales price per unit/service – variable costs per unit service
Example: If fixed costs are $100,000, the unit sales price is $200 and the variable cost per unit is $100, the break even point is $100,000 divided by $200 minus $100. That means you must sell 1,000 units to break even.
Why it’s smart to understand your business numbers
Even if you have a bookkeeper, accountant or chief financial officer crunching the numbers, it’s still crucial you have a basic understanding how the accounting was done. “It would be difficult for [the business owner] to really be able to understand what the business is doing if they don’t understand how the numbers they are seeing on their financial reports were created,” Thompson said. Here are a dozen other reasons to understand these formulas:
- Plot the financial future and health of the business.
- Improve decision-making to keep the business on track with goals and objectives.
- Prepare annual budgets for revenues and expenses.
- Compare budgets to actual income and expense activity.
- Identify if you need to implement cost-cutting measures.
- Reduce the risk of spending more money than receipts or, conversely, not spending enough to grow.
- Manage cash flow for payroll and vendor/supplier payments.
- Determine opportunities to increase profit margins.
- Assess the break even point to determine how many sales you need to cover expenses.
- Ascertain if there is enough money to adequately fund operations.
- Decide if and when you need to apply for financing and/or working capital.
- Make continuous improvements and anticipate problems.
The bottom line
Having the ability to produce a balance sheet and income statement is key for decision-making, creating budgets and gaining access to capital. Accounting formulas help project cash flow and determine whether it can cover necessary expenses, according to Thompson. Two main ways businesses fail is because they lack cash and don’t have a good accounting system in place to enable business owners to make sound decisions.
“That’s why the accounting formulas are so important,” said Thompson. “It tells [business owners] what cash they have, and if they don’t know that, they’re not going to survive,”