Accounting Equations 101 - What to Know for Your Business
Maintaining the financial health of your business is no easy feat. At times, even bookkeepers and accountants find it challenging to keep financial records and crunch the numbers for accounting purposes. That is why proper and robust accounting of all financial transactions should be put in place.
If you own a small-scale business, the chances are that you don’t have an accountant and have been dealing with numbers on your own. It makes sense, however, to hire an accountant who can better manage your balance sheet and business transactions.
Below are some basic accounting equations that every business should know.
1. Basic accounting equation
In the basic accounting equation, the total assets of your business should be equal to the sum of your liabilities and equity. Below is the basic formula:
Total Assets = Liabilities + Equity
Assets: These refer to all the things your company owns. These can include property, cash, inventory, accounts receivable, and equipment.
Liabilities: These refer to the obligations that your company has to pay. These include lease payments, merchant account fees, accounts payable, and any other debt service.
Equity: This pertains to the portion of the company that belongs to the owner. For instance, if a number of shareholders own the company, then the stockholders’ equity will fall under this category.
2. Net income
Net income is basically a measure of the profitability of a business venture. The goal is to achieve a positive net income, which means that your business is profitable. Net income can be calculated by subtracting your revenue from your expenses.
Net Income = Revenues – Expenses
Revenues: These refer to the positive cash inflow that goes into your company as a result of the business venture.
Expenses: These pertain to the costs incurred to generate revenue.
3. Break-even point
Simply put, the break-even point indicates how much your business needs to sell to cover all your costs and generate a profit of $0.00. This means that if your sale goes over the break-even point, your business is generating a profit. Here’s the basic formula:
Break-Even Point = (Sales – Fixed Costs – Variable Costs = $0 Profit)
Fixed costs: These refer to recurring, predictable costs of your business. Examples of these are insurance premiums, rent, employee salaries, and others that your business must pay regularly.
Sales: These pertain to the sales prices charged multiplied by the number of units sold.
Variable costs: These refer to any changing costs based on the number of units produced or sold.
3. Cash ratio
The cash ratio aims to let you see how much cash your business currently has. It gives you a better understanding of how your business can pay its existing liabilities. As per the equation, the higher the number, the healthier your business is.
Cash Ratio = Cash ÷ Current Liabilities
Cash: This refers to the amount of money you have at your disposal, which can include the actual cash and cash equivalents.
Current liabilities: These pertain to the current debts of your business.
4. Profit margin
The profit margin records the net income earned on each dollar of sales. This can be calculated by dividing your net income by your sales. While a high-profit margin indicates a healthy financial, low-profit margin indicates that your business does not handle your expenses well.
Profit Margin = Net Income ÷ Sales
Net Income: This refers to the total amount of money your business has made after removing expenses.
Sales: These pertain to the operating revenue you generate from business activities.
Having a basic understanding of accounting is essential for your business. Knowing how to calculate accounting equations will help you achieve a more in-depth financial understanding. The numbers and results are vital in helping you come up with sound business decisions. This post will help you maintain the financial health of your company. If not, maybe it’s about time to hire an accountant for your business.
If you’re looking for a business accountant in Gold Coast, get in touch with us today to see how we can help.