Whether you have an accountant on staff or you would rather manage your business’ finances on your own, there are some fundamental accounting equations that you should know to better understand the health of your business. We list the most important ones below.
Assets = Liability + Stockholders’ Equity
This is called the accounting equation or balance sheet equation. It’s used to understand the financial position of a company through the economic resources it owns and the sources of financing for those resources.
Assets are the resources owned by the entity, while liabilities and stockholders’ equity are the sources of financing. More specifically, liabilities are the amount of financing provided by creditors, in other words, the company’s debts or obligations. Stockholders’ equity is the amount of financing provided by the owners of the business and reinvested earnings.
It is important to know this equation because it is at the basis of all business transactions and the two sides of the equation must always be in balance if your bookkeeping is accurate.
Net Income = Total Revenues — Total Expenses
Net income, or net earnings, is the excess of total revenues over total expenses. A loss results if total expenses exceed total revenues, while a profit is generated if revenues are greater than expenses.
Revenues include the cash and promises received from the delivery of goods and services. Expenses are the resources used to earn revenues.
This equation is important because it reports the profitability of the company. Investors and shareholders will want to know this number to judge the business’ performance.
Break-Even Volume = Fixed Costs / (Sales Price — Variable Cost per Unit)
This formula is used to calculate the amount of product your business will need to produce to cover the total costs of production.
Fixed costs are those expenses that do not change depending on the number of goods or services produced. The sales price represents the price paid by a customer to purchase a particular good or service. And the variable cost per unit refers to the expenses involved in the production of the goods which are dependent on the volume of output.
Business owners must know this equation to better understand the cost structure, determine prices, and formulate a business plan.
Current Ratio = Current Assets / Current Liabilities
This is a liquidity ratio used to measure the company’s ability to pay short-term obligations.
Current assets are the economic resources of a company that are convertible to cash within a year. These include cash and cash equivalents, short-term investments, accounts receivable, inventory, supplies, prepaid expenses, etc. Current liabilities are the company’s obligations that are to be paid within a year. For example, short-term loans payable, accounts payable, income taxes payable, deferred revenues, accrued liabilities, etc.
It is especially important to understand what is meant by this ratio. A higher current ratio is more favorable because it means current assets are greater than current liabilities. Instead, a low current ratio, especially if it’s below 1, indicates an issue because the company is unable to cover its current liabilities.
Cash Ratio = Cash / Current Liabilities
This is another liquidity ratio used to measure a company’s ability to cover short-term obligations using cash and cash equivalents.
The two components of this equation are cash and current liabilities. Cash includes bills, coins, bank accounts, as well as other currencies and undeposited cheques. While current liabilities are the company’s short-term debts.
Knowing the cash ratio is useful to measure whether the company has enough liquid assets to pay its current liabilities if it were required to do so immediately.
Profit Margin = Net Income / Revenue
This is an equation to measure the degree to which a business makes money.
The components are net income and revenues. Net income, or net earnings, is revenues minus expenses. Revenue is the total income from sales of goods and services. It is calculated by multiplying the number of sales by the sales price.
This equation shows how much of every dollar earned from sales the company keeps from its earnings. It is important for business owners to know because by comparing it to the industry’s standard profit margins, one can judge the wellbeing of the company.
Debt-to-Equity Ratio = Total Liabilities (Debt) / Total Equity
This ratio measures the degree to which a company is financing its operations through debt versus owned funds. In other words, it is the shareholders’ ability to cover outstanding debts, and it should technically stay below two.
Total liabilities are the short and long-term obligations that a company has. Total equity represents the amount of money invested in a company by shareholders, plus the business’ earnings, minus the dividends paid.
The Debt-to-Equity ratio is used by potential investors and stakeholders to evaluate the financing strategy of the company. A low ratio indicates less risk, while a high ratio means that the company is unable to cover debts with equity.
Gross Margin = (Net Sales — Cost of Goods Sold) / Net Sales
Gross Margin represents the sales revenue retained after incurring the costs associated with producing the goods.
Net sales are gross sales (all transactions reported within a period) minus sales allowances, discounts, and returns. Cost of goods sold (or COGS) are the costs associated with the production of goods sold by a company.
It is important to measure the efficiency of the business by calculating whether the company’s sales are enough to cover the costs.
COGS = Beginning Inventory + Purchases of Inventory — Ending Inventory
As mentioned before, the cost of goods sold is the cost of producing the goods that a company sells.
Beginning inventory is the amount of the company’s inventory at the start of the accounting period. Purchased inventory is the amount of inventory that the company purchases during the accounting period. And ending inventory is the book value of the company’s inventory at the end of the accounting period.
Assessing the cost of goods sold will help you recognize what departments are using up most of the company’s resources. If COGS increase, it means the net income will decrease. Thus, understanding COGS is important for business owners to make adjustments with the aim of maximizing profitability.
Retained Earnings = Beginning Retained Earnings + Net Income (or Loss) — Dividends
This equation is used to find the net income left over after the business has paid dividends to shareholders.
Beginning retained earnings refers to the previous accounting period’s retained earnings. Net income is the profit earned by the company during the accounting period. Dividends represent the money or stocks distributed by the company to its stockholders.
Knowing how to calculate your retained earnings is essential to recognize whether you have the means to grow your business. These can be used to fund expansions, pay dividends later, pay back loans, or invest in various projects.
These are the ten most important equations that you, as a business owner, should be familiar with to stay on top of your business’ accounting and make more informed business decisions.