Accounting Equations Every Business Owner Should Know

By: First Union


Accounting Equations Every Business Owner Should Know

Small business owners in particular, often take care of the company's accounting on their own. Some businesses are simply too small or are just starting out and so hiring a full-time accountant to handle the books may not be feasible. That said, if you are tackling your company's finances, there are certain formulas and accounting equations that you are going to need to be aware of. In this article, we look at a few key accounting equations and discuss why these are critical for any business owner to understand.

Understanding Some Accounting Basics

While you may not be extremely well-versed in accounting practices and procedures, if you are tending to your books as a small business owner, you are going to have to familiarize yourself with some accounting basics and accounting equations. First off, we will review a few of the more important terms that any entrepreneur should understand when it comes to accounting.

  • Accounts Receivable: This is the money that a customer owes for products/services they've purchased.
  • Accounts Payable: On the flip side, this is the money that the company owes to suppliers for example for certain purchases.
  • Financial Statements: There are several financial documents that a business should prepare. This could be the balance sheet, income statement, profitloss statement—all of these are known as financial statements.
  • Balance Sheet: A type of financial statement that details a company's assets, liabilities, and owner's equity.
  • Cash flow Statement: This is one such financial statement that details how much money is going out and how much consequently is coming in.

Accounting Equations

While there are many accounting equations that businesses use to keep track of the overall picture of their financial health, below are a few of the more important ones that you should know and thereby be prepared to generate for your company.

1. Balance Sheet

Among the most important accounting equations is the balance sheet equation. It is relatively simple and yet so incredibly important to help your company stay out of the red and maintain a solid financial picture. You will list out all assets of the company. This could include property, inventory, any equipment, cash, anything of this nature. You will also list all of the business's liabilities on the balance sheet. So in this section, you have all of the company's financial obligations to include accounts payable, mortgages, and any other such debts. The balance sheet also shows the equity. This simply means the owner's share of the company. Stockholder's equity would fall into this category as well. In terms of the equation itself, the assets have to equal liabilities plus equity for the sheet to balance out.

2. Net income equation

With the net income equation, we get to see how profitable a firm is. For those companies seeking out investors, knowing where your net income stands and being able to show this is critical. Net income equals your revenue minus all expenses. So in this case, you would factor all relevant income streams, and then when deducting expenses, this represents all costs that the business incurs. Once you subtract all expenses, what you are left with is the bottom line, or in other words, the company's net income for that given period. You want this to be a positive number.

3. Cash ratio equation

In the course of doing business, owners will often have to take on debt for a variety of reasons. This debt can take the form of mortgages, business loans, and also pension obligations for example. With the cash ratio equation in accounting, you are focused on the firm's liquidity or its ability to pay off its obligations. Cash ratio equals your cash (or cash equivalents/) divided by current liabilities. Cash equivalents can be highly liquid investments—we are not strictly talking about actual cash here. Current liabilities are of course all current business debts.

The resulting ratio can show you how much cash you currently have in conjunction with your ability to pay off all of your debts should the need arise to do so. A higher ratio is a healthier one.

4. Profit margin equation

When it comes to understanding your company's overall financial health, the profit margin equation is among the most useful to this end. This shows you how the business is using income to create wealth. The equation is as follows: profit margin = net income divided by sales. Your net income is the money the business has as a result of revenue and following the deduction of all expenses. Sales simply refer to the operating revenue you make.

Dividing net income by the sales shows you your profit margin. The profit margin signifies the amount of money you make on each dollar earned. So if this number is high that is going to be better than a low-profit margin percentage.

5. Cost of goods sold equation

The cost of goods sold, or COGS represents what it costs to make and sell your product. The COGS is directly related to product manufacturing/shipping/sales and does not take into account things such as overhead expenses or long-term expenses. Knowing what the COGS is can tell you how efficient the company is when it comes to creating products for the consumer. The formula here involves taking your beginning inventory number plus the cost of new inventory minus ending inventory. So you'd account for what you have at the beginning of the reporting period in terms of inventory, you would add to that what you spend on new inventory/materials for product manufacturing, and then you would deduct whatever inventory you have left at the end of the said reporting period.

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