Most of us long for the good old school days. One not-so-great aspect of school nostalgia is mathematics. It certainly wasn’t a pleasant experience when we were jamming dozens of complex equations and formulas into our brains before a final exam.
It’s genuinely blood boiling how most of those formulas don’t have a lot of practical uses. Plus, technological advances, for example, MS Excel is already turning regular math and statistics into remnants of the past. But, can you believe that some of those formulas are incredibly beneficial in our adult lives?
On the other hand, accounting formulas offer greater practicality and a broader scope for real-life applications. Because of this quality, accounting formulas are easier to memorize and use in business.
Managing business finance can become quite overwhelming. Usually, businesses have a full-time accounting function to handle and maintain their finances. However, most entrepreneurs try to save their hiring costs. They prefer to keep the responsibility of maintaining their books of accounts to themselves.
If you’re able to relate to such entrepreneurs, you better wise up, kid. Down below, we’ll be listing some standard accounting formulas that you need to know. It wouldn’t be wrong to consider these formulas as universal to all businesses. They bring you the required figures to understand the viability of your business and its financial health.
The Accounting Equation or Balance Sheet Equation
The Method: Assets = Liability + Capital / Owner’s Equity
Madness Behind It: If you’re an accounting amateur, forget everything else and learn this formula first. Everything that a firm owns for a future benefit is called an asset — for example, property, equipment, and cash. Liabilities comprise debt and other payment obligations such as supplier payments, lease payments, and short-term loans. Capital or owner’s Equity is the portion of the business or the investment that solely belongs to its owner.
You can guess the significance of this equation because few online masters in accounting no gmat, and most bachelor’s of accounting include it in their first classes.
The Method: Profit Margin = Net Income / Sales
Madness Behind It: The revenue you generate from your selling your merchandise/services is known as sales. Net income equals the total income of your business after disbursing its expenses. Divide the two to calculate your business’ profit margin.
Higher profit margins depict a long and profitable business life. Lower margins indicate how unsuccessful a company might be. It could also mean that your firm is not managing its expenditures efficiently.
Keep in mind that you get net income by subtracting expenses from total revenue. So, having a high sales revenue and a small profit margin demands a closer look at all the accounts included in your net income.
The Method: Break-Even Point = Fixed Costs / Sales – Variable Cost per Unit
Madness Behind It: Think of your fixed costs as the recurring expenses utilized in the day-to-day running of your business, for instance, rent, salaries, and insurance premiums.
The retail price of your services or goods constitutes your sales price. The amount it takes to manufacture a particular product individually is known as variable cost per unit.
You can arrive at your break-even point by dividing your fixed costs and the sale price minus the cost of one individual product. This point is essential in determining how much you should sell to have enough money for expenditures.
The Method: Cash Ratio = Cash Balance / Current Liabilities
The Method: This ratio is crucial in determining the liquidity of a business. The total amount of cash currently at your disposal equals your cash balance. For example, cash may comprise paper money and cash equivalents such as marketable securities. Your current liabilities include all the debts you incur and have to settle in the present, i.e., under one year.
Cash ratios reveal a business’ capability to pay off its current liabilities. Therefore, the higher this figure, the more prosperous a business.
Cost of Goods Sold
The Method: Cost of Goods Sold = Cost of Materials and Inventory – Costs of Outputs
Madness Behind It: Cost of inventory and materials means the money your firm disburses to acquire the necessary raw materials or products for goods manufacturing.
Cost of Outputs means the cost of all other factors contributing to the total cost of the goods sold, for example, transportation.
When you minus the output costs from the cost of materials, you can calculate the cost of goods sold. COGS lets you know your product’s carrying value and whether its costs align with the revenue it generates.
The Method: Retained Earnings = Initial Retained Earnings + Net Income or Net Loss – Cash Dividends
Madness Behind It: Take retained earnings as a safety reserve fund of a business. They constitute the sum of all net profits minus all cash dividends since business formation. Beginning Retained Earnings means retained earnings balance carried forward from the previous operating period or fiscal year.
Net profit/loss equals the remaining balance after you deduct expenditures from revenues. Sometimes, this balance may be negative. Cash dividends consist of payments to the owners of a business’ common stock.
The statement of retained earnings enables businesses to analyze net income/profit after giving out shareholder dividends. Hence, retained earnings allow for a more detailed financial analysis. Even if your firm paid no dividends, always create the retained earnings statement at the end of every period.
The Method: Net Income = Revenues – Expenses
Madness Behind It: Any positive cash inflows into the business, combined with your sales, constitute your revenues. On the contrary, expenses include the costs related to sales and any negative cash outflows.
You can calculate your net income by simply subtracting total expenses from your total revenues. When the day is done, this amount represents the money you’ve earned. For start-ups, this figure may be negative as their business is still in the growth phase. So, your ultimate goal should be to maintain a positive net income, which in turn, makes your business more profitable.
The Method: Debt-to-Equity Ratio = Total Liabilities / Total Equity
Madness Behind It: Total liabilities comprise all your payables to outside stakeholders, for example, loan payments and annual interest installments. As mentioned previously, total equity represents the portion of a business that solely belongs to its owner. You can also regard it as the amount of money one invests in their own business.
Higher debt-to-equity ratios demonstrate that you depend upon outside sources for a large proportion of your financing, such as banks and other financial institutions. Suppose you’re searching for investors or looking to secure more funds for your firm. In that scenario, a low debt-to-equity ratio may make it easier and faster to bag funding.
A well-structured accounting system enables the proper evaluation of your business’ financial health. This article left out many useful formulas. Still, with a knowledge of basics such as the accounting equation, COGS, cash ratio, and debt-to-equity ratio, you stand indestructible. These essential accounting formulas will provide you a better understanding of your business and help you proactively direct it toward prosperity and profitability. Is there a more practical use for mathematics? We didn’t think so!