11 Accounting Formulas Small Business Owners Need to Know
If you’re a small business owner who likes to do their own bookkeeping, you’re not alone. According to a recent report by Clutch, a majority of small businesses (62%) prefer to do their accounting in-house.
Luckily, you don’t have to be an accountant to assess your business’ financials. Use these tried-and-true accounting formulas to quickly and accurately gauge your company’s financial health.
Table of contents
- Accounting equation formula
- Break-even point formula
- Cash ratio formula
- Cost of goods sold formula
- Debt-to-equity ratio formula
- Gross profit and gross profit margin formulas
- Inventory shrinkage formula
- Markup percentage formula
- Net income formula
- Return on investment formula
- Straight-line depreciation formula
1. Accounting equation formula
Liability + Owner’s Equity = Assets
- Liabilities are what your company owes, including regular expenses (such as your lease, accounts payable, and loan payments).
- Owner’s equity represents the money you’d have at your disposal if you liquidated all company assets (turned them into cash).
- Assets are what your company owns: cash, property, inventory, equipment, etc.
Why you should know the accounting equation formula
The accounting equation is the big kahuna of formulas. It’s sometimes called the balance sheet equation as well. This most basic accounting equation has only one purpose—to show you whether your financial statements and records are accurate.
Italian mathematician Luca Pacioli created this formula over 500 years ago in his “A Treatise on Accounts and Records.” It’s the basis of the double-entry bookkeeping system that’s used today by businesses large and small.
Accounting equation example
Say your liabilities total $15,000, and your owner’s equity is $35,000. Your current assets should then total $50,000.
If the sum of your liabilities and owner’s equity is not equal to that of your total assets, you have errors in your bookkeeping that need to be fixed.
2. Break-even point formula
Fixed Costs / (Sales Price Per Unit – Variable Cost Per Unit) = Break-Even Point
- Fixed costs are your everyday, recurring expenses—such as rent, payroll, insurance premiums, and utilities.
- Sales price per unit is how much you are asking for your product or service—the selling price.
- Variable cost per unit is the cost of the materials and labor that go into creating your product/service.
Why you should know the break-even point formula
This formula shows you how much of your product or service you need to sell in order to cover your operating costs.
Your break-even point is the point at which your revenue is equal to your costs. Exceed your break-even point to turn a profit. If you aren’t reaching the break-even point, your business is operating at a loss.
Break-even point example
Let’s say your fixed costs (payroll, rent, utilities, etc.) are $5,000 per month. You have a pizza restaurant that sells pies for $10, which is your sales price per unit.
It costs $6 in materials and labor to make one pizza pie. That’s your variable cost per unit. Now plug those figures into the formula:
$5,000 / ($10 – $6) = 1,250 units
You need to sell 1,250 pizza pies per month to break even.
3. Cash ratio formula
Cash / Current Liabilities = Cash Ratio
- Cash includes both actual cash and cash equivalents, such as investment securities that can easily become cash.
- Current liabilities are the debts that your business currently owes.
Why you should know the cash ratio formula
This formula lets you know how much cash you currently have at your disposal. As a measure of your business’ liquidity, the cash ratio helps you understand how easily your company can pay off its debts if it needs to. The higher the cash ratio, the healthier your company’s financials.
A cash ratio can either be greater than or less than 1. If your cash ratio is less than 1, you have more liabilities than cash and cash equivalents. If it’s greater than 1, it means you can cover all your short-term debt and have cash to spare.
Cash ratio example
If your company has $500,000 in cash and cash equivalents and current liabilities of $200,000, that means that you have a cash ratio of 2.5.
Your cash ratio is greater than 1, meaning that you’ll be able to pay all your current liabilities and still have $300,000 left.
4. Cost of goods sold formula
Beginning Inventory + Purchases of Inventory – Ending Inventory = Cost of Goods Sold
- Beginning inventory is the total value of your in-stock inventory that you can sell to generate revenue.
- Purchases of inventory is the cost of the new inventory you purchase throughout the month.
- Ending inventory is the value of the inventory that is still available and for sale at the end of the month.
Why you should know the cost of goods sold formula
Cost of goods sold, often abbreviated as COGS, refers to the direct costs of producing the products or services that your company sells. It does not represent indirect expenses like sales, marketing, or distribution costs.
Most point-of-sale systems automatically calculate COGS. Whether you have one or not, it’s good to know how to manually calculate the cost of goods sold.
Cost of goods sold example
Let’s say that your company sells staplers. At the beginning of the month, you have an inventory of 500 staplers. Each stapler is worth $3, so your beginning inventory’s value is $1,500 (500 × $3).
Over the course of the month, you purchased 35 more staplers at the same price of $3 per stapler. That’s an added $105 (35 × $3) of purchased inventory.
You sell 80 staplers this month, so you have 455 staplers left as your ending inventory. The total value of these staplers is $1,365 (455 × $3).
Now let’s put all these numbers into the formula:
$1,500 (beginning inventory) + $105 (purchased inventory) – $1,365 (ending inventory) = $240
Your cost of goods sold is $240.
5. Debt-to-equity ratio formula
Total Liabilities / Total Equity = Debt-to-Equity Ratio
- Total liabilities include the money you are regularly paying to outside parties that are financing your business. They are the combined debts that your company owes, such as loans and interest rates.
- Total equity is the portion of the company you actually own.
Why you should know the debt-to-equity ratio formula
This formula helps assess your company’s financial structure. If your debt-to-equity ratio is high, that means that most of your business’ financing comes from outside sources, like banks. A high ratio makes your business a risky investment, while a low debt-to-equity ratio makes you more attractive to banks and investors.
Debt-to-equity ratio example
Let’s say that your company has $200,000 of total liabilities coming from several bank loans and $300,000 of total equity. That means that you have a relatively low debt-to-equity ratio of 0.67.
If you only had $100,000 of total equity, that would mean that your debt-to-equity ratio is 2, which is high. As a result, investors and banks would be very cautious about giving you more money. They are essentially looking at how easy it would be for them to earn their money back on the investment. If you have two times more liabilities than equity, the chances of a quick and easy return on investment for them are fairly slim.
6. Gross profit and gross profit margin formulas
Sales – Cost of Goods Sold = Gross Profit
- Sales refer to the total amount of money generated from selling your products or services during a certain period.
- COGS, as we’ve already noted, is the direct cost of producing your goods, such as labor and materials.
Gross Profit / Sales = Gross Profit Margin
- Gross profit, above, is the amount of money your company earns after subtracting the costs associated with producing your goods.
- Sales, as mentioned above, is the amount of money you earn selling your goods.
Why you should know the gross profit and gross profit margin formulas
Gross profit and gross profit margin are often confused, and it’s easy to understand why. Both of these formulas gauge a company’s profitability.
Gross profit describes something commonly referred to as top-line earnings—your revenue minus your direct COGS. Gross profit margin shows your gross profit as a percentage. Both figures are telling you the same thing but in a different format.
Gross profit and gross profit margin examples
Let’s say you’re selling lawnmowers, and you’ve made $20,000 this month in total sales. The COGS was $10,000, making your gross profit $10,000.
$20,000 (sales) – $10,000 (COGS) = $10,000
You can now calculate your gross profit margin by dividing your gross profit by your sales ($10,000 / $20,000 = 0.5).
That’s a 50% gross profit margin, which is pretty great.
7. Inventory shrinkage formula
Inventory Cost on Record – Physical Inventory Cost = Inventory Shrinkage
- Inventory cost on record is the value of your inventory that you have in your account books.
- Physical inventory cost is the value of the inventory that you actually have in your possession. To get this number, you are going to need to take a physical count of your inventory.
Why you should know the inventory shrinkage formula
If you are seeing an increase in inventory shrinkage, there’s a good chance that someone is stealing from you. There is inventory listed in your accounting records that isn’t found in your actual inventory.
Inventory shrinkage could also result from miscounting, not using the right units of measure, or unclear cooperation with third parties. For example, your supplier could charge you for 100% of the goods you requested but only deliver 96% of them.
Inventory shrinkage example
Say you have $300,000 in inventory cost listed in your accounting records. After conducting a physical inventory check, you find out that your physical inventory cost is $285,000. Therefore, your inventory shrinkage is $15,000.
$300,000 (inventory cost on record) – $285,000 (physical inventory cost) = $15,000
You can also calculate your inventory shrinkage percentage by dividing your shrinkage by your inventory cost on record. Here, your inventory shrinkage percentage would be 5%.
8. Markup percentage formula
Markup Price (Selling Price – Unit Cost) / Unit Cost × 100 = Markup Percentage
- Selling price is the price your customers are paying for your product.
- Unit cost is how much it costs you to produce and sell your product.
Why you should know the markup percentage formula
The only way to earn money on what you’re selling is to charge more than it costs for you to create and sell it. The markup percentage is the amount that you are adding to your wholesale price in order to turn a profit.
Markup percentage example
Say it takes $50 to create and sell your product, which is your unit cost. If your selling price is $75, that means that the markup price is $25. Now find the markup percentage using the formula:
($75 – $50) / $50 = .50 × 100 = 50%
Your markup percentage is 50%—a common rate that’s considered a safe bet for being able to turn a profit in most industries. Your markup percentage should be enough to give you a good chance of making money even when your sales are down, or your costs increase.
9. Net income formula
Revenue – Cost of Goods Sold – Expenses = Net Income
- Revenue is the positive cash flow that your company earns through sales.
- COGS is the cost of the materials and labor that go into producing your goods.
- Expenses are all the other costs that help you to make a sale.
Why you should know the net income formula
Often confused with the net cash flow formula, the net income formula shows you the total amount of money your business earns once you’ve paid all business expenses, taxes, and interest.
Your net income tells you if your business is profitable. You’ve probably heard it referred to as a business’ “bottom line.” (Fun fact: that nickname comes from the fact that net income (or net profit/net earnings) is often listed at the bottom of your income statement.)
When your net income is positive, you have money left over to make investments, pay outstanding debts, or save for a rainy day. If it’s negative, then you didn’t earn a profit.
Net income example
Let’s say you have a bicycle shop and sold 40 bikes for $400 each this month. That would make your total revenue for the month $16,000. Your COGS is $4,000.
Your expenses (rent, utilities, payroll, marketing) came to $6,000. Now that we have all the elements, let’s calculate your net income:
$16,000 – $4,000 – $6,000 = $6,000
Your net income for the month is $6,000. Congratulations, you are running a profitable business!
10. Return on investment formula
(Net Return on Investment / Cost of Investment) × 100 = Return on Investment
- Net return on investment is the amount of money you’ve made from the investment.
- Cost of investment is the amount of money spent for the initial investment.
Why you should know the return on investment formula
Return on investment (ROI) is a widely used formula that lets you know whether an investment you have made has paid off. It compares the gain or loss from the investment against the initial cost of the investment.
Many businesses use ROI even before they make an investment to understand how much net ROI they need to turn a profit and whether it’s worth pursuing.
Return on investment example
Let’s say you wanted to make an investment in the stock market and bought 2,000 shares of a company. Each share costs $12. Your cost of investment is $24,000.
$12 (initial cost per share) × 2,000 (number of shares purchased) = $24,000
One year later, each share is worth $16. If you sell the shares now, you will earn $32,000.
$16 (new price per share) × 2,000 (number of shares owned) = $32,000
That gives you a return on investment of $8,000 since you bought the shares for $24,000, and they are now worth $32,000.
However, you need to subtract $180 because that’s what you spent on trading commissions when buying and selling the shares. Therefore, your net return on investment is actually $7,820.
Now take your net return on investment and divide it by your original cost of investment. Then multiply that number by 100 to get your ROI percentage.
($7,820 / $24,000) × 100 = 32.58
Your ROI on the investment is 32.58%. That’s pretty darn good.
11. Straight-line depreciation formula
(Cost of Asset – Salvage Value) / Useful Life of Asset = Straight-Line Depreciation
- The cost of your asset is the total amount you paid for it (including shipping, taxes, installation, etc.).
- Salvage value is the price that you can sell it for once it stops being useful.
- The useful life of the asset is how many years you think you’ll be able to use it.
Why you should know the straight-line depreciation formula
Straight-line depreciation is the simplest way to calculate how much value a fixed asset loses over time.
It assumes a constant rate of depreciation. If the value of an item decreases by $20 over the course of one year, it’s going to continue decreasing by $20 every year after.
Businesses often use this accounting formula when filing taxes and writing off purchases like tools and equipment.
Straight-line depreciation example
Let’s say you spent $500 on your printer. That’s the cost of your asset. You think you’ll be able to use it for five years, which is the useful life of the asset. After five years of using it, you estimate that you’ll be able to get $30 for it. That’s the salvage value.
Let’s plug all that data into the formula:
($500 – $30) / 5 years = $94
The value of your printer decreases by $94 each year.
Combine traditional accounting formulas with modern tools
On paper (or the computer screen), these accounting formulas and equations seem pretty straightforward. In reality, business owners know how hard it is to compile and reference all the elements needed for the formulas to work their magic.
Luckily, there’s easy-to-use accounting software like Neat available to small business owners who need a little help organizing their receipts, invoices, and expenses. When your bookkeeping is clean, it’s much easier to plug the right numbers into these standard accounting formulas.
To see how easy it is to use our small business bookkeeping software, sign up for a free trial today.
March 31st, 2022
June 26th, 2020