Understanding the financial health of your small business is crucial for long-term success. While accounting can seem daunting, mastering a few key formulas can provide valuable insights into your business’s performance. Small business math formulas are calculations used to assess financial health, profitability, and operational efficiency.
This guide presents the most important accounting formulas you need to know. To deepen your understanding, consider exploring books on small business accounting to complement these foundational formulas.
The Balance Sheet Equation
Assets = Liabilities + Equity
The balance sheet equation, also known as the basic accounting equation, is the cornerstone of accounting. It shows how your assets are financed through debt (liabilities) and owner’s contributions (equity). This equation ensures that your balance sheet remains balanced.
Understanding the Balance Sheet Equation
- Assets: What your company owns, including cash, inventory, and property.
- Liabilities: What your company owes, such as loans and accounts payable.
- Equity: The residual interest in the assets of the company after deducting liabilities, often referred to as owner’s equity.
For instance, if your company has assets worth $50,000, liabilities of $15,000, and owner’s equity of $35,000, your balance sheet will be balanced.
Current Ratio
Current Assets / Current Liabilities = Current Ratio
The current ratio, also known as the acid test ratio, measures your ability to pay short-term obligations with your short-term assets.
Calculating the Current Ratio
If your business has $8,000 in current assets and $2,000 in current liabilities, your current ratio is 4. This indicates that you can cover your short-term debts four times over, suggesting good liquidity. However, an excessively high ratio might indicate inefficiency in using assets.
Net Income
Income – Expenses = Net Income
Net income, or the bottom line, indicates your profitability. This formula subtracts your expenses from your income to show how much profit you retain after all costs.
Importance of Net Income
Net income is crucial as it shows the efficiency of your operations. However, it does not account for cash flow, which is why it’s important to manage your cash separately. For instance, if your income is $16,000, your cost of goods sold is $4,000, and your expenses are $6,000, your net income is $6,000.
Cost of Goods Sold (COGS)
Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold
COGS calculates the direct costs attributable to the production of goods sold by a company. This formula helps in determining the gross profit.
Calculating COGS
If you start with an inventory valued at $1,500, purchase additional inventory worth $105, and end with an inventory valued at $1,365, your COGS is $240. This figure helps in assessing the cost efficiency of your production process.
Gross Profit and Gross Profit Margin
Sales – Cost of Goods Sold = Gross Profit
Gross Profit / Sales = Gross Profit Margin
Gross profit and gross profit margin are vital indicators of your company’s financial health. Gross profit shows the money earned after deducting the COGS, while gross profit margin indicates the percentage of revenue that exceeds the COGS.
Example Calculation
If your sales are $20,000 and your COGS is $10,000, your gross profit is $10,000. To find the gross profit margin, divide the gross profit by the sales, resulting in a 50% margin. This means half of your sales revenue is profit before other expenses.
Break-Even Point
Fixed Costs / (Sales Price Per Unit – Variable Cost Per Unit) = Break-Even Point
The break-even point tells you how much you need to sell to cover your costs.
Calculating Break-Even Point
For example, if your fixed costs are $5,000 per month, you sell pizzas at $10 each (sales price), and it costs $6 to make one pizza (variable cost), you need to sell 1,250 pizzas to break even.
Cash Ratio
Cash / Current Liabilities = Cash Ratio
The cash ratio measures your ability to pay off short-term liabilities with cash or cash equivalents.
Understanding Cash Ratio
If your business has $500,000 in cash and $200,000 in current liabilities, your cash ratio is 2.5, indicating strong liquidity and financial health.
Debt-to-Equity Ratio
Total Liabilities / Total Equity = Debt-to-Equity Ratio
This ratio shows the proportion of debt and equity financing your company uses.
Example Calculation
If your business has $200,000 in liabilities and $300,000 in equity, your debt-to-equity ratio is 0.67, suggesting a lower risk to investors compared to a higher ratio.
Inventory Shrinkage
Inventory Cost on Record – Physical Inventory Cost = Inventory Shrinkage
Inventory shrinkage measures the difference between recorded and actual inventory, indicating potential theft or errors.
Calculating Inventory Shrinkage
If your recorded inventory is $300,000 but your physical count is $285,000, your shrinkage is $15,000, or 5%.
Markup Percentage
(Selling Price – Unit Cost) / Unit Cost × 100 = Markup Percentage
This formula helps you determine the percentage added to your cost to set the selling price.
Example Calculation
If your unit cost is $50 and your selling price is $75, the markup percentage is 50%. This ensures you cover costs and earn a profit.
Return on Investment (ROI)
(Net Return on Investment / Cost of Investment) × 100 = Return on Investment
ROI measures the profitability of an investment.
Calculating ROI
If you invest $24,000 in stocks and sell them for $32,000, after deducting $180 in trading commissions, your net return is $7,820. Dividing this by your initial investment and multiplying by 100 gives an ROI of 32.58%.
Straight-Line Depreciation
(Cost of Asset – Salvage Value) / Useful Life of Asset = Straight-Line Depreciation
This method calculates the depreciation expense of an asset over its useful life.
Example Calculation
If you purchase a printer for $500, expect it to last five years, and estimate a salvage value of $30, the annual depreciation is $94.
By mastering these essential accounting formulas, you can effectively manage your business’s financial health, make informed decisions, and ensure long-term success.
