Having a firm grasp of your company’s financial situation can provide a source of satisfaction — or cause for concern. While accounting software handles much of the number-crunching needed to generate a balance sheet and a profit and loss statement, as a business owner you should understand these 7 accounting equations to give you a reliable way to assess the financial well-being of your company.
1. Calculating the balance sheet equation for your business
This accounting formula provides a snapshot of your firm’s fiscal health, and it’s known as the balance sheet equation. This is because the dollar value of your assets must equal the sum of your liabilities and equity.
Total assets = liabilities + equity
Your assets include equipment, inventory, cash, property, and accounts receivable. Liabilities include all of the obligations you have, such as accounts payable, merchant fees, loan and lease payments, and any debts you are servicing. Equity is your share of the business that you own.
2. Determining your net income
This next calculation is an excellent indicator of your company’s profitability. If you are seeking investors, this is a particularly relevant issue because they will want to know your net income, which is calculated as follows:
Net income = revenues – expenses
While it’s not unusual for a young business to show a net loss, consistent profitability is the goal for an established business.
3. Calculating whether you’re breaking even
We’ve all heard the saying, “You have to spend money to make money.” You know firsthand that numerous expenses are necessary to operate your business. But keeping up with paying your bills quickly becomes problematic if your business is not breaking even.
Completing this accounting equation shows whether you can meet your expenses and turn a profit. It’s known as the break-even point equation.
Break-even point = (sales – fixed costs – variable costs = $0 profit)
Your fixed costs are the predictable, regularly recurring expenses that your business incurs in order to operate, such as bills, rent, and salaries. Sales are the number of units sold multiplied by the price you charge your customers. Your variable costs are the expenses that change depending on the quantity of units sold or produced.
This calculation shows you how much you must sell to meet your costs and break even. Profit is generated with every dollar you generate past the break-even point.
4. Figuring the cost of goods sold
This fourth calculation gives you a clearer understanding of how efficiently your products are created. This accounting equation is performed for a specific period of time. To perform the calculation, you will need to know how much inventory you have when the time period begins, how much you spent during the time period to acquire the materials needed to create your product, and how much product you have left when the time period ends. Then you apply your numbers in this equation:
Cost of goods sold = beginning inventory + cost of purchasing new inventory – ending inventory
This tells you how much it cost to create the product you sold. To determine your gross profit, you can subtract the costs of goods sold from your revenues for that time period.
Is your business operating efficiently?
5. Calculating your profit margin
The profit margin equation shows how your company uses revenues to produce profits.
Performing this calculation not only offers you a snapshot of your company’s financial well-being, but also provides a way for you to develop a better strategy for profitability.
Profit margin = net income ÷ sales
You determined your net income using the formula in item 2 above. Your sales are the revenue your business generates. Dividing the net income by sales calculates your company’s profit margin. If your profit margin is high, congratulations — your business is financially sound. If your profit margin is low, you may want to take a closer look at your operations to determine where changes can be made to boost profits.
6. Determining your debt-to-equity ratio
The sixth accounting equation is debt-to-equity ratio. This is used to determine how much debt your company is using to finance operations. It can help you understand how stable your business is.
Debt-to-equity ratio = total liabilities ÷ total equity
Your total equity is a measurement of how much of the company truly belongs to you and reflects how much you have invested in the business. If you are seeking investors or additional financing, you want to avoid having a high debt-to-equity ratio.
7. Calculating your business’s liquidity
Running a business typically involves using credit, which can include business loans, pension obligations, mortgages, and more. If you needed to pay off all of your liabilities at once, it would require liquidity. To determine your company’s liquidity, you can use the cash ratio calculation.
Cash ratio = cash ÷ current liabilities
In this scenario, cash includes the money on hand plus any assets that are highly liquid, like stock investments; your liabilities encompass your company’s current debts.
Putting It All Together and Mapping a Course of Action
Ultimately, if you perform the accounting equations described here and find that your results are less than stellar, it may be time to take a look at how effectively your business is using its assets to generate income. As a general rule, your operational costs should be 60% or less of your revenue, and expenses should be 30% or less of revenue. If your business is falling short of your expectations, it’s time to take a hard look at operations and set a new course to address your concerns.
If you’re looking to increase your business efficiency and bottom line, you may want to consider a variety of strategies. These could include using software to automate processes, shopping suppliers for better deals on materials, finding ways to improve energy efficiency and reduce overhead, and reevaluating whether less popular products should remain part of your offerings.
Don’t underestimate the value of talking to others in your field who are likely grappling with similar challenges. Professional networks can serve as useful sources of information and ideas. But if you’re facing challenges that feel overwhelming or demoralizing, it may be time to hire a business manager or consultant to support your goals.
Whatever strategy you choose, performing the accounting calculations described here will provide essential information to help you better understand your business’s financial situation — and make informed decisions.