Essential Accounting Equations For Business Owners
Accounting equations? Do business owners really need them? Well, the answer is yes. A bit of calculation is necessary to balance your accounts and stay abreast of a business's finances. In big firms, accountants take care of this aspect of business, but for most small businesses with spending constraints, owners themselves may choose to run the books. If you fall into this category, there are basic accounting equations you should know.
The sound of equations scares some business owners, but the essentials are not intricate formulas or tough mathematical models. By understanding the parameters, using these equations is easy and additionally, they are applied in almost every type of business. Let's examine some important and basic ones.
Before diving into these equations, here are basic terms to keep in mind:
An asset is the totality of things belonging to a business. It includes property and equipment in shape to provide benefits.
Liabilities are mandatory payments in form of purchases, debts, and other compulsory running costs.
Owner's Equity is the percentage of the business that belongs solely to the owner.
Net income reflects the business's profit or loss. Your net income will give insight into the total profit your business has made at the end of a business period.
To calculate net income, you will need to know the revenue and expenses for a certain timeline. At the early stages of a small and growing business, the net income may indicate a loss. Why? Let's analyze the expenses and revenue, then the reason for the loss in the early days of a business becomes clear.
Revenues refer to sales and other generated income for a business. While Expenses connote the costs of running the business to generate income.
Hence, Net income = Revenues - Expenses.
Since a business spends more at the start, those periods may reflect negative numbers; the business has more expenses than revenues. As the business grows, the narrative should change.
The cash ratio is an indicator of the capability of a business to pay off liabilities. It's the ratio of what your business has at its disposal. The parameters involved are cash and current liabilities.
Cash, be literally or an equivalent in investment, is the amount a business has at its disposal. While Current Liabilities are the number of debts of a business at a period. This ratio is fair when there is a higher cash amount than the liabilities.
Cash ratio is calculated as Cash ÷ Current Liabilities.
Debt to Equity Ratio
Here's another ratio with deciding factors. The debt to equity ratio may affect getting funds from creditors if the debt is higher than the equity.
Often calculated as Total Liabilities (debts), which is the amount payable to third parties like loan repayment and other forms of payment. And the other value; Total Equity is the amount invested in the business by the owner.
To calculate, it's Total Liabilities: Total Equity.
The Break-Even Point helps to decide how many products or services a business must sell to cover all costs and record profit. To calculate this, the fixed costs must be known. The Fixed Costs are the reoccurring necessary business operating costs which encompass the salaries, rent, etc.
Next is the Variable Cost per Unit. It's the amount of manufacturing a product or service per unit. And the last one sales price. The Sales Price is the amount a unit of product or service sells for.
To calculate this, use this simple method: (Fixed Costs / Sales Price) – Variable Cost Per Unit.
It means you'll divide Fixed Costs by Sales prices, then subtract the result from the Variable Cost Per Unit. The final result shows the volume to be sold to cover costs.
A profit margin is calculated by knowing the net income and sales number. A high profit margin is good for business while a low one requires attention to pull the business off the brink of collapse.
The Net Income is the total amount gained after the removal of expenses. And sales is the amount from sales.
To calculate: Net Income / Sales.
This means your net income should be divided by the sales. The result will indicate a high or low-profit margin.
Cost of Goods/Services Sold
To know the cost of goods sold, you need to know the cost of materials and outputs cost. The cost of material is calculated by noting the amount it takes to acquire materials used in product manufacture. And Cost output is the total cost of sold goods.
To use this, simply say: Cost of Materials & Inventory – Cost of Outputs
It means you'll remove the cost of outputs from the cost of materials. This helps to determine if the cost paid for production commensurate with the selling amount.
Retained earnings are important for business analysis. It's a full overview of all earned net income from the start of business minus the all paid cash dividends.
Calculated as Beginning Retained Earnings + Net Income or Net Loss – Cash Dividends.
The beginning retained earnings are the retained earnings from a previous business year. The Net Income is the total amount left after expenses are subtracted from revenues. And lastly, Cash Dividends are payments to stock owners.
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