The 6 Most Important Accounting Formulas You’ll Ever Need to Know
The most important accounting formulas are practical and intuitive, making them easy to remember and apply.
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Accounting formulas help you better understand your business's financial health. And fortunately, many accounting software products do most of the calculations for you. Still, it's helpful to know what's going on behind the scenes.
Here are the top six formulas business owners should know:
1. Balance sheet equation
Some people call it the basic accounting equation. Essentially, it provides a snapshot of your business's worth at a specific point in time.
Here's the equation:
Assets = Liabilities + Equity
In other words:
What you own (assets) = What you owe (liabilities) + Your contributions or retained earnings in the business (equity)
This makes our list of important accounting formulas because it helps you measure your business's health at a glance. For example, let’s say you have $15,000 in assets. This includes your bank account balances, accounts receivable and other assets, like computers and furniture.
Now, let’s say your liabilities total $5,000. This is the total of all debts you owe — credit cards, lines of credit, accounts payable, etc.
This means your equity is $10,000. This is the sum of your combined contributions and profits you have not taken out of the business in the form of draws and distributions.
2. Current ratio, or acid test ratio
This accounting formula tells you how quickly you can pay your short-term debts. The equation is:
Current Assets / Current Liabilities = Current Ratio
Using our example above, let’s say of the $15,000 in total assets, $8,000 is in current assets. A current asset is cash or something that can easily be converted to cash, such as accounts receivable and short-term investments.
Now, let’s say, of your $5,000 in liabilities, $2,000 is current. A current liability is debt due within the next 12 months. Accounts payable, credit card balances and short-term lines of credit are all current liabilities.
Using our equation above, the current ratio is 4.
$8,000 / $2,000 = 4
This means you have four times as many current assets as you do current liabilities. In other words, you could pay your short-term debt four times before running out of cash.
Ideally, your current ratio should always be greater than 1. A current ratio that is too high, though, can indicate you aren’t managing your capital efficiently. As a result, your business growth could stagnate.
3. Net income
Net income, or the bottom line, is a measure of profitability. Basically, it tells you whether you're spending too much in relation to your revenue. The equation is:
Income – Expenses = Net Income
Let's say your business made $50,000 in sales and $2,000 in interest the first quarter. But you also spent $5,000 on cost of goods sold and $12,000 in taxes. That means your net income was $35,000
($50,000 + $2,000) - ($5,000 + $12,000) = $35,000
It’s important to note that net income does not equal cash in the bank. Payments on liabilities — the debts you owe, which appear on the balance sheet — are not included in the net income equation. Neither are contributions of capital, draws and distributions, or asset acquisition.
4. Cost of goods sold
Most accounting software and point-of-sale (POS) systems will calculate cost of goods sold for you. However, it's good to know what factors into it. The formula for cost of goods sold is:
Beginning inventory value + Purchases of inventory – Ending inventory value = Cost of goods sold
Let’s say you own a lumberyard. At the beginning of the month, you had 10,000 2x4s in your yard, valued at $2 each. This means you started the month with $20,000 worth of 2x4s. Over the course of the month, you bought 5,000 2x4s, again at $2 each. That’s $10,000 more worth of 2x4s.
At the end of the month, you count your 2x4s, and you have 8,000 left. Since the cost of the 2x4s didn’t change, you have $16,000 worth of 2x4s. Plugging these numbers into the equation, you can calculate your cost of goods sold:
$20,000 + $10,000 – $16,000 = $14,000
Therefore your cost of goods sold for the month was $14,000.
You can now use your cost of goods sold number and your total sales number to determine your gross profit.
5. Gross profit and gross profit margin
Gross profit is the difference between your total sales income and cost of goods sold. Here's the equation:
Sales – Cost of goods sold = Gross profit
Remember those 2x4s you had in your lumberyard? Let’s say your total sales of 2x4s for last month was $21,000. We’ve already calculated your cost of goods sold above, so you can easily determine your gross profit:
$21,000 – $14,000 = $7,000
Your gross profit last month was $7,000.
Now, let's calculate your gross profit margin:
Gross Profit / Sales = Gross Profit Margin
In this case, your gross profit margin is 33%.
$7,000 / $21,000 = .33
Here's some good news: You don't have to boost sales to increase your gross profit margin. Instead, you can try decreasing your cost of goods sold.
For example, let’s pretend your cost of goods sold last month was $13,000 instead of $14,000. That would make your gross profit $8,000 and your gross profit margin on $21,000 in sales 38% instead of 33%. And you didn’t have to sell more 2x4s to get there.
6. Break-even point
This formula tells you how much of your product or service you need to sell to cover operating costs. You calculate your break-even point as follows:
Fixed costs / (Sales price per unit – Variable cost per unit) = Break-Even Point
Your fixed costs are your normal, recurring and predictable expenses. Rent, payroll, utilities, etc., are all fixed costs.
Your sales price per unit is the selling price of your product or service.
Your variable cost per unit is basically your cost of goods sold. That’s not the exact definition, but using your cost of goods sold will generally get you close enough.
Going back to our lumberyard example, let’s say rent, payroll, utilities, and all other operating costs total $6,000/month. You sell your 2x4s at $3 per board, and you know your cost of goods sold is $2 per unit. Your break even point, then, is:
$6,000 / ($3 – $2) = 6,000 units
Therefore, you have to sell 6,000 2x4s in order to break even for the month.
You can also calculate your break-even point in dollars:
Sales price per unit x Break-even point in units = Break-even point in dollars
So, you need $18,000 in sales to break even for the month.
$3 x 6,000 = $18,000
The moment you exceed your break-even point, your business becomes profitable. For the 2x4s in your lumberyard, that occurs when you sell your 6,001st 2×4 in a month, or after you exceed $18,000 in 2×4 sales.
A version of this article was first published on Fundera, a subsidiary of NerdWallet.
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