Remember math in high school, when you had to memorize dozens of accounting formulas to pass the final exam?
Fortunately, in the real world, you will only need to use a fraction of the accounting math you learned in school. Here are our six best formulas to help you stay on top of your small business accounting:
1. The balance sheet equation
Also known as the basic accounting equation, the balance sheet equation explains exactly how the balance sheet balances. This equation is:
Assets = liabilities + equity
What you own (assets) = what you owe (liabilities) + your contributions or retained earnings in the business (equity)
That makes our list of important accounting formulas, because once you get the hang of it, you can see at a glance how healthy your business is. For example, let’s say your bank account balance, plus your other assets (like computers, furniture, etc.) and your accounts receivable add up to $ 15,000. This is the “assets” part of the balance sheet, or the entire upper part of it.
Now let’s say your debts total $ 5,000. This is the total of all the debts you owe – credit cards, lines of credit, accounts payable, etc.
This means that your capital – the total of your combined contributions and profits that you did not take out of the business in the form of drawings and distributions – is $ 10,000. Congratulations! You most likely have a healthy, profitable business, assuming you don’t provide the business with large amounts of resources to keep it afloat.
2. Current report or acid test report
This important concept is high on the list of important accounting formulas and tells you how quickly you can pay off your short-term debts. The equation is:
Current assets / current liabilities = Current ratio
Using our example above, let’s say that of the $ 15,000 in total assets, $ 8,000 is in current assets. A current asset is cash or something that can easily be converted to cash, such as accounts receivable and short-term investments.
Now, say, of your $ 5,000 in liabilities, $ 2,000 is common. A current liability is a debt due in the next 12 months. Accounts payable, credit card balances and short-term lines of credit are all current liabilities.
Using our equation above, the current ratio is 4 ($ 8,000 / $ 2,000 = 4). This means that you have four times more short-term assets than short-term debt, or you could pay off your short-term debt four times before you run out of cash.
Ideally, your current ratio should always be greater than 1. Too high a current ratio, however, may indicate that you are not managing your capital effectively and, as a result, your business growth may stagnate.
3. Net income
Net income, or bottom line, is a measure of profitability. The equation is:
Income – Expenses = Net income
This important accounting formula tells you at a glance if you are overspending relative to your income. It’s important to note, however, that net income does not equate to cash in the bank. Payments on liabilities – debts you owe, which show up on the balance sheet – are not included in the net income equation. Capital contributions, withdrawals and distributions or the acquisition of assets are not either.
So the net income equation shows you how profitable your business operations are, but not how healthy your cash flow is.
If you need to create an income statement, you can do so with QuickBooks.
4. Cost of goods sold
Of course, the cost of goods sold should be on our list of important accounting formulas. Most accounting and point-of-sale systems calculate the cost of goods sold for you. However, it sometimes becomes necessary to perform this calculation manually. The cost of goods sold formula is:
Starting Inventory Value + Inventory Purchases – Ending Inventory Value = Cost of Goods Sold
Let’s say you own a lumber yard. At the start of the month, you had 10,000 2x4s in your yard, worth $ 2 each. This means you started the month with $ 20,000 from 2x4s. During the month, you bought 5,000 2x4s, still at $ 2 each. That’s $ 10,000 from 2x4s.
At the end of the month, you count your 2x4s, and you have 8,000 left. Since the cost of 2x4s has not changed, you have $ 16,000 of 2x4s. By plugging these numbers into the equation, you can calculate your cost of goods sold:
$ 20,000 + $ 10,000 – $ 16,000 = $ 14,000
Therefore, your cost of goods sold for the month was $ 14,000.
You can now use your cost of goods sold and your total number of sales to determine your gross margin.
5. Gross profit and gross profit margin
Here’s another critical concept that makes our list of important accounting formulas.
Gross profit is the difference between your total revenue from sales and your cost of goods sold:
Sales – Cost of goods sold = Gross profit
Do you remember those 2x4s you had in your lumber yard? Let’s say your total 2×4 sales for the past month were $ 21,000. We have already calculated your cost of goods sold above, so that you can easily determine your gross margin:
$ 21,000 – $ 14,000 = $ 7,000
Your gross profit last month was $ 7,000.
Now let’s calculate your gross profit margin:
Gross profit / sales = gross profit margin
Your gross profit margin is 33%.
As you can see, anything you can do to increase your gross margin increases your gross profit margin. And increasing your gross profit margin has a direct impact on your bottom line. Increasing your gross profit margin by decreasing the cost of sales allows you to increase the profitability of your business without increasing sales.
For example, imagine the cost of goods sold last month was $ 13,000 instead of $ 14,000. This would make your gross profit of $ 8,000 and your gross profit on sales of $ 21,000 38% instead of 33%. And you didn’t have to sell more than 2x4s to get there.
6. Break-even point
This formula tells you how much of your product or service you need to sell to cover your operating costs. This equation takes a little more work to calculate, but it is one of the most important accounting formulas you can use in your business. You calculate your breakeven point as follows:
Fixed costs / (Sales price per unit – Variable cost per unit) = breakeven point
Your fixed costs are your normal, recurring, and predictable expenses. Rent, payroll, utilities, etc. are all fixed costs.
Your selling price per unit is the selling price of your product or service.
Your variable unit cost is essentially the cost of goods sold. This is not the exact definition, but using your cost of goods sold will usually get you close enough.
Going back to our lumberyard example, let’s say rent, payroll, utilities, and all other operating costs add up to $ 6,000 per month. You sell your 2x4s for $ 3 per board and you know your cost of goods sold is $ 2 per unit. Your breakeven point is therefore:
$ 6,000 / ($ 3 – $ 2) = 6,000 units
Therefore, you need to sell 6000 2x4s to break even for the month.
You can also calculate your breakeven point in dollars:
Unit selling price x Break-even point in units = Break-even point in dollars
So you need $ 18,000 in sales to break even for the month.
Why is it important to know your breakeven point? As soon as you exceed your breakeven point, your business becomes profitable. For 2x4s in your lumber yard, this happens when you sell your 6,001st 2×4 in a month, or after you have exceeded $ 18,000 in 2×4 sales.
A version of this article first appeared on Fundera, a subsidiary of TBEN.