As a business owner, you deal with many numbers every day. Whether you do your own bookkeeping or outsource it to an accountant or bookkeeper, you face the numbers of your business regularly. But what to do with these numbers? Accounting equations help you to make sense of the numbers that you see. Putting your numbers into various accounting equations shows you how you can use the raw financial data from your business to monitor your business’ progress and success. This in turn will help you to make key financial decisions.
Sounds great, right? But many people are intimidated or turned off by accounting equations and ratios. Even the sound of the word “accounting” is enough to make some people’s eyes glaze over. But as a business owner, understanding accounting equations is power. They give you the ability to understand firsthand where your business is succeeding and failing, and how to make the necessary adjustments to correct your course. No longer do you need to rely on an expert to interpret your numbers for you – the knowledge is yours. So, small business owner, venture forward and learn: understanding your finances is within your grasp.
The Accounting Equation
As a small business owner just beginning to learn about managing and understanding business finance, the first thing you will need to know is the double-entry accounting equation. It is the foundation of double-entry accounting.
Assets = Liabilities + Equity
So when you put these pieces together, what do you get? Basically, it means that every dollar and every item that your business owns was bought or otherwise acquired in one of two ways. Either you, the business owner, borrowed money (a liability) to purchase what the business owns (assets) or you financed it yourself with money that you saved to get your business off the ground (equity).
Here’s an example: Suppose you bought a new computer for your business (an asset) that cost you $800. Your assets in your business have now increased by $800. In order to buy that laptop, you put $100 in cash down on the purchase, and financed the rest of the computer’s cost through the electronics store. The $700 which you financed will be listed in your accounting as a liability, or debt. Now you have $100 that is left to make the accounting equation balance. This piece is equity that you have in the computer, and in your business as a whole.
As your business grows, both sides of your equation will grow as well. Your business will have more and more assets available, and those assets will be financed either through further borrowing (increasing liabilities) or profits reinvested into the business (equity). Depending on your business structure, you may have different ratios of debt and equity, and different sorts of assets, liabilities, and equity on your balance sheet.
Gross Profit Margin
If you are in business, you need to be making a profit. The gross profit margin accounting equation tells you what percentage profit you are making. The gross profit margin is calculated as total income after expenses/total sales revenue.
Gross Profit Margin = Income/Sales
This tells you how much of each dollar of sales is going to keeping your business running (expenses) and how much you actually get to take home or reinvest (profit). For instance, if you made $100,000 in sales, but had a net income of only $40,000, your gross profit margin would be 40%. If you have a high profit margin, you have low expenses and a very profitable business. If you have a low profit margin, you have much higher expenses and lower profits. You may want to brainstorm different ways to lower expenses, raise sales, or both. Different industries will have different profit margins.
You cannot rely solely on the accounting ratio number to tell you whether your business is doing well. Comparing your gross profit margin accounting ratio to others within your specific niche will be a better indicator of business strength or weakness.
Return on Assets
This accounting ratio is another metric of strength for your business. The accounting equation is calculated as net income divided by total assets. For instance, if your business made $100,000 in net income and had total assets of $500,000 in a year, you would have a return on assets (ROA) ratio of 0.2, or 20%.
ROA = Total Assets/Net Income
What does this number mean? This means that for every dollar of assets you have, you made 20 cents in sales. The ROA measures how hard your assets are working for you to make your business money. A higher ROA means that your assets are heavily focused on generating income. Perhaps you have invested a large sum of money into a software program that identifies your ideal customer for you, or you have a lot of money tied up in inventory that sells well. A lower ROA means that your assets are focused elsewhere than sales. Maybe your assets are more heavily focused on cash, land, or some other asset class that is less directly related to revenue.
Again, the ideal ROA will vary depending on your industry or niche. Generally speaking, a higher ROA indicates more efficient usage of your assets to generate profits.
The quick ratio, or acid test ratio, is a measure of how quickly you could pay off your current liabilities in an emergency. It is calculated as current assets divided by current liabilities.
Now, we discussed what assets and liabilities are – current assets and current liabilities are subsets of assets and liabilities.
Quick Ratio = Current Assets / Current Liabilities
Current assets are assets that are readily available to you within a short window of time – usually one to three months. Cash and accounts receivable are examples of current assets. Land, buildings, and equipment are generally not considered current assets, as they are usually not able to be liquidated quickly if the business needs the money.
Current liabilities are debts that are due within a short window of time, similar to current assets. For example, a bill due to a supplier would be a current liability. A mortgage, on the other hand, would not entirely be a current liability as it is debt over a much longer period of time.
So why do you need to know the quick ratio? Suppose that your business had some kind of emergency, or there was a natural disaster that prevented you from doing any business or making any sales for an entire month. If you have a quick ratio over 1, meaning that you have more current assets than current liabilities, you would still be able to pay all your immediate bills even without any sales. A quick ratio less than 1 might mean that you need a bit more of a cash cushion for emergencies in your business.
Break Even Point Formula
The break-even point formula is the most complicated of the accounting equations we have looked at so far. The break-even formula is a measure of how many units you must sell at a given price to cover all your costs.
Break Even Point = Fixed Costs / (Selling price per unit – Variable Cost per unit)
Let’s walk through this with an example. Suppose your company makes widgets. You sell each widget for $5. The first step to calculating break-even is to calculate the variable costs per unit. These are things such as raw materials and packaging costs that are directly tied to each unit of product made. Each widget costs $1.50 in variable production costs.
The next step is calculating the fixed costs. These are costs tied to manufacturing, but not directly to the unit, such as the lighting in the factory. Your fixed costs for the widget operation are $10,000 per month.
The last piece you need is the selling price per unit. As noted above, the selling price per unit is $5. Once you have all these pieces of information, you can calculate the break-even point. First, you subtract the variable cost per unit from the selling price per unit. This gives you the amount of the selling price that must cover the fixed costs, known as the contribution margin. For our widgets, the contribution margin is $3.50. You then take the total fixed costs of $10,000 and divide it by the contribution margin. 10,000 divided by 3.50 gives us a break-even point of 2,858 widgets. This gives you the number of widgets that you must sell to cover your fixed costs.
Now you probably want to know how to use the break-even point. Knowing all these numbers and how they are related to each other allows you to see where your biggest costs are. High fixed costs may mean that you have to sell many more units to make a profit. You can then make important management decisions, such as cutting fixed or variable costs wherever possible, and deciding what sales goals to set for the month and the quarter.
Small business owner, you now know some of the most important accounting equations and how to use them. Use your newfound knowledge to increase your business power and make the best decisions possible. Take your accounting knowledge and win!
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