6 Most Important Accounting Formulas You’ll Ever Need to Know
Keeping a track of finances and revenue is of prime importance to businesses of any dimension. Some practical and intuitive accounting formulas are used by businesses all over, to monitor cash flow statements, manage business transactions, prepare balance sheets and financial statements.
Don’t get frightened! You do not need to memorize dozens of accounting formulas like you did during your college days. In the world of business accounting, you will only need to use a handful of these formulas. In this blog, we will look at 6 such accounting formulas you just can’t afford to ignore, if you want to have complete control over your business accounting.
Here we go!
The Balance Sheet Equation
This is one of the most basic accounting equations, but, still very useful in modern business accounting. This equation explains how the balance sheet can be balanced. The equation can be written as:
Assets = Liabilities + Equity
Assets=what you own
Liabilities = what you owe, and
Equity= retained earnings or contributions to the business
This formula is important to your business accounting as understanding it properly would give you a fair idea of the ‘health’ of your business. An example will help you more. Let us assume the total balance of your bank accounts, other assets (furniture, computer etc.) and your accounts receivable is $20,000. This will constitute the Assets section of the balance sheet.
Again, let us assume your total liabilities amount to $10,000. This includes all the debts owed by you — credit cards, accounts payable, lines of credit and so on.
Now, your total equity will be = $20,000- $10,000= $10,000. This is the total of your contributions and profits that have not been taken out of the business as draws and distributions. This figure will also show that in all probability, your business is a healthy and profitable one, as you are not spending too many resources to keep your business afloat.
Net income, also called the bottom line, can provide a good measure of the profitability of your business. The equation can be written as:
Income – Expenses = Net Income
This important formula lets you know if you are spending too much of your revenue. Please note that the net income does not amount to the total cash left in the bank. Also, your debts appearing on the balance sheet (Payments on liabilities) are not parts of the net income equation. It does not take into account the capital contributions, asset acquisition, draws and distributions as well.
The net income accounting formula depicts how profitable your business is. However, it can not give you an idea of how good your cash flow is.
Also called the acid test ratio, this important accounting formula tells you how soon you will be in a position to pay your short-term debts.
The equation is written as:
Current Assets / Current Liabilities = Current Ratio
Here is one example to help you understand the concept better. Let’s assume your business has a total asset of $15,000. Out of this, $8,000 is in current assets, which is either cash or something easily convertible to cash (for example, accounts receivable, short-term investments and so on)
Now, let us again assume that you have $5,000 in liabilities and out of this, $2,000 goes into current liabilities. A current liability is nothing but your debt due for clearance within the next 12 months. Current liabilities include credit card balances, short-term line of credit and accounts payable.
In our example, the current ratio is = $8,000 / $2,000 = 4. This would show your current assets are 4 times that of your current liabilities. This means your business is in a position to pay your short-term debt 4 times before it runs out of cash.
The current ratio of your business should always be more than 1. However, you can’t afford to have a current ratio that is too high. Such a current ratio would indicate you have not been able to manage your capital efficiently, which may stagnate your business growth in the days to come.
Cost of Goods Sold
This important accounting formula will give you an idea of how much it would cost to create the products you sell. It gives a measure of how efficiently you are creating the products. This formula can be stated as-
Beginning Inventory + Cost of Purchases of New Inventory – Ending Inventory = Cost of Goods Sold
Beginning Inventory– It is the inventory you hold at the start of the accounting period
Cost of Purchases of New Inventory- the amount of money spent to obtain the necessary materials and products to manufacture the good you sell.
Let us give you an example. Let’s say you are the owner of a lumberyard. Also, at the start of the month, you possessed 10,000 2x4s, each valued at $2. During the month, you bought 5,000 2x4s more, at the same price. That was an expenditure made of $10,000 in 2x4s.
Next, you were left with 8,000 2x4s at the end of the month. This means you had 2x4s worth $16,000, assuming the cost of the 2x4s remained the same. Considering these numbers and using the equation, your cost of goods sold in during the month will be:
$20,000 + $10,000 – $16,000 = $14,000
Now, you can calculate your gross profit with the help of the cost of goods sold amount and the total sales number.
Gross Profit and Gross Profit Margin
The gross profit of your business is equal to the total sales income minus the cost of goods sold. The equation can be written as:
Sales – Cost of Goods Sold = Gross Profit
Let us go back to our example of 2x4s in our previous section. Let us assume you sold 2x4s worth $21,000 last month. We already found your cost of goods sold to be $14,000. Therefore, your gross profit can be easily calculated as :
$21,000 – $14,000 = $7,000
Now, we will calculate your gross profit margin by using the formula:
Gross Profit / Sales = Gross Profit Margin
=$7,000 / $21,000 = .33
Therefore, your gross profit margin stands at 33%.
From this equation, you can have an idea that by increasing your gross profit you can increase the gross profit margin. Also, increasing your gross profit margin directly impacts your net income. you can decrease the cost of sales, increasing the gross profit margin land thus, can grow your business profitability even without increasing sales.
Another example will make it clear for you. Let us assume your cost of goods sold during the last month was $13,000. Using the same equation, we will get that your gross profit is $8,000 and your gross profit margin stands at 38%. if you compare it with the previous example, you will notice that your gross profit margin increased from 33% to 38%, without you selling any more 2x4s.
You may find this formula a bit hard to calculate but, it is one of the most important formulas for your business. It informs how much of the product /service you should sell to meet your operating costs. In other words, the break-even point is the point where your total sales meet the total expenses. You do not generate any loss or profit when you reach the break-even point.
The break-even point formula can be written as:
Break-Even Point =Fixed Costs / (Sales Price Per Unit – Variable Cost Per Unit)
Here, all your recurring, normal and predictable expenses are categorized as fixed costs. Utilities, payroll, rent etc. are examples of fixed costs.
The selling price of your product/service is termed the Sales price per unit.
Your cost of goods sold may be termed as the variable cost per unit.
Let’s get back to our example of the lumberyard again. Let us assume your operating costs and rent, utilities and payroll add to $6,000/month. Moreover, the selling price of 2x4s is currently fixed at $3 per board and your cost of goods sold stands at $2 per unit.
Therefore, your break even point can be calculated as:
$6,000 / ($3 – $2) = 6,000 units
This means you will need to sell 6,000 2x4s to reach the break-even point for the month.
To calculate the break-even point in dollars, you can use the below-mentioned formula-
Break-even point in dollars = Sales price per unit x Break-even point in units
In our example, you will need to spend $3 x 6,000 = $18,000 as sales revenue to break even for the month.
Having a proper idea of the break-even point is very important for your business. Once you surpass the break-even point, you start making profits. In our example, you start making a profit as soon as you sell the 6,001st 2×4 in a particular month, or once you exceed $18,000 of sales revenue while selling 2×4s.
In order to assess the financial health of your business accurately, you need to have a comprehensive accounting system and a properly maintained general ledger. Of course, there exist a plethora of accounting formulas for your use, but the ones mentioned in this blog are the key formulas you just can’t afford to ignore.
All these equations may seem straightforward to you. But, they can be complicated in reality. Many business owners find it challenging to balance the equations while considering the huge number of accounts they maintain in their company.
This is where accounting software can come to your rescue. Here, all you need to do is to enter your business transactions. The software will crunch the numbers and will make it easier for you to analyze your business health. With such software, you can also streamline your accounting operations and run your business more efficiently.
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