The 5 Most Important Accounting Formulas
Looking for the best accounting formula equations for your business? This guide compiles the most valuable accounting equations for small businesses and gives an in-depth analysis of their specific uses and advantages.
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Top 5 Accounting Equations for Small Business
Adequately managing a business’s finances is commonly done via the incorporation of a variety of different equations and formulas.
This can significantly improve a business’s long-term growth prospects and profitability in a calculated and sustainable way.
The equations we’ve researched and listed below are generally applicable to almost all businesses regardless of their size and industry, and they are commonly used to produce essential components of a business’s financial standing, such as its balance sheet and income statement.
Here are our top five accounting formulas that every business owner should know.
1. The Accounting Equation
The accounting equation is one of the most important elements of a business’s balance sheet.
Small business owners commonly have to use the assets that they initially contributed towards their business in order to acquire additional assets that may be pivotal for the day-to-day operations or the expansion of their company.
When this happens, the business in question incurs a debt or a liability in exchange for obtaining a certain asset (e.g., cash or any other sort of monetary gain). At the same time, the incurred liability acts as a future “obligation” for the business as, until it is repaid, the relative creditor(s) will have a claim upon the assets that the business originally borrowed in the past.
This means that the financial nature of liabilities — and their influence over a business’s “real ownership” — has in the past made it necessary to establish a third-tier of classification. This is where the accounting equation comes into play.
The accounting equation can be expressed as:
Assets = Liabilities + Capital
In essence, this means that you can use the above formula to accurately ascertain the exact proportion of your business that belongs to yourself (and not to any creditors).
2. Sales to Administrative Expenses Ratio
One of the most important steps for young business owners is working out exactly how much overhead expense they need in order to achieve or maintain a specified level of sales volume.
The sales to administrative expenses ratio is extremely important as it can ensure that your business’s administrative expenses are carefully controlled so that they do not have a high impact on your company’s total profits.
The formula for calculating your sales to administrative expenses ratio is:
Sales to Administrative Expense Ratio = Sales / Administrative Expenses
For example, when X business experiences a rather sharp drop in their sales volume, they may rely on this ratio to determine that their administrative expenses have increased relative to their sales revenue (e.g., from 1:0.1 to 1:0.2)- meaning that their total administrative costs have pragmatically doubled in relation to their total sales revenue.
This accounting formula allows business owners to ascertain whether they can reduce their administrative costs so that they are at a comparable proportion to the figure that existed before the sales drop, which may involve merging departments or outsourcing personnel.
Overall, quick managerial actions based on the sales to administrative expense ratio can generally allow you to shrink your business’s administrative costs so that you can maintain a satisfactory level of profit in times of decreased total revenues.
3. Sales to Equity Ratio
A business’s sales to equity ratio is used to determine the amount of equity that should be retained within a business as sales volumes begin to fluctuate.
For example, if a business experiences significant sales growth, it will likely require a considerable amount of capital so as to sustain a proportionately high level of sales growth, which can be “achieved” through debt, internal cash generation, or, of course, equity.
Similarly, this ratio can additionally be used to determine if too much equity has accumulated in a business, which may lead you to decide to extract a “reasonable” proportion through a plethora of common forms of distribution, such as an increase in dividends or a stock buyback.
The accounting formula for a business’s sales to equity ratio is:
Annual Net Sales / Total Equity
It should be noted that if a business is already highly leveraged — meaning that it has significantly more debt than equity — the amount of equity in it is likely to be so small that the sales to equity ratio will seldom be relevant.
Moreover, business owners deciding to shift away from debt to more equity (or vice versa) will practically have a significant impact on their business’s sales to equity ratio — even where no real change in total sales has occurred.
This means that your managerial decisions will ultimately play a pivotal role in the holistic impact of this accounting formula.
4. Discretionary Cost Formula
The discretionary cost accounting formula is extremely important, particularly if your business is currently experiencing a rather “tight” cash flow situation that you are expecting to be able to reasonably overcome in the long term.
This is because it can be used to determine what costs your business can “dispense with” in the short term in order to bring you back to a more neutral or profitable financial situation.
Your company’s discretionary costs can be calculated using the following formula:
Discretionary Costs / Sales Revenues
For example, if a company’s industry is hit exceptionally hard by an unforeseeable event, its business owner(s) may elect to utilize this accounting formula to diminish what they’ve concluded to be “discretionary expenses” such as meals, entertainment, and employees.
Consequently, they may be able to proactively offset a rather large dip in total revenues (and profits) by choosing to cut down on costs that are not imminently necessary.
5. Break-Even Point
The break-even point accounting formula is used to describe the real relationship between a business’s: fixed costs, variable costs, and returns. Simply put, a break-even point indicates the point in time where a proposed investment will begin to generate a profit for the business owner(s) involved.
This can be determined using this simple mathematical equation:
BE = F / (S - V), where:
- BE = break-even point
- F = total fixed costs
- V = variable costs per unit of production
- S = savings or additional returns per unit of production
For example, a farmer raising 1,200 acres of wheat per year may consider purchasing a combine. When ascertaining how long it would take for such a business decision to become profitable, they would initially need to consider the additional fixed and variable costs that would be incurred- such as the extra land, management, and/or labor that would be required.
Then, the farmer would need to calculate the precise amount of capital that would be saved (through the additional income generated) and subtract that from the sum of his fixed and variable costs.
This means that, before choosing to purchase the additional 1,200 acres, the farmer would be able to realize how long it would take for the benefit gained from the extra land (e.g., the increase in savings or additional returns per unit) to surpass the initial costs incurred.
Why Is Accounting Important for My Small Business?
Accounting is essential for small businesses as it allows a company’s managers, owners, and potential investors to evaluate the long-term financial performance and prospects of the company using calculated, predictable, and tangible methods (including the accounting formula ratios listed above).
The principal purpose of accountancy is to serve as a mechanism through which business owners can identify and record comprehensive financial records of their company’s day-to-day operations — ensuring that they always comply with the filing requirements issued by federal government bodies such as the IRS.
Can I Be My Own Accountant?
Even though hiring your own accountant may not be a legal requirement, you may be wondering whether hiring one is likely to greatly benefit your business, or whether it would be better to handle your financial administrative duties independently.
Below are a few general rules for you to follow, though bear in mind that these may vary significantly depending on your business’s size, entity structure, and industry.
Generally speaking, you will likely benefit significantly from hiring an accountant if you are interested in:
- Complying with tax-related issues
- Handling complicated payroll structures
- Being assisted with state and federal filing requirements
This means that even when accountants aren’t necessarily required, they can benefit businesses through:
- Achieving and maintaining “smart” and financially sound growth
- Covering any legal blindspots
- Ensuring all quarterly tax requirements are satisfied
If you are a relatively small freelancer and/or your business’s tax standing is relatively straightforward and non-complex (such as with a sole proprietorship or general partnership), you will likely be able to get away with handling these sort of administrative procedures on your own. That being said, this may not be the most temporally efficient choice
Frequently Asked Questions
Am I legally required to have an accountant?
Contrary to popular opinion, there is currently no legal requirement for businesses of any size to hire an accountant. Having said that, it should be noted that many business structures (particularly incorporated structures) may find hiring an accounting specialist beneficial for certain filing mandates.
How much does hiring an accountant cost?
Most personal accountants and accounting firms tend to charge their clients per hour. The average fees for this range anywhere between $150 and $250 per hour, although this can vary depending on your accountant’s location, experience, and eminence.
How should I choose an accountant for my business?
In order to choose the most optimal accountant for your business, you should initially determine your specific requirements, as well as your budget. Knowing the exact degree of assistance that you will need can allow you to tailor both your time and your resources towards your most efficacious options straight from the get-go.
What are the alternatives to hiring an accountant?
If you are not happy with hiring an accountant — or if your budget does not allow you to do so at the moment — you could always handle your financial administrative duties and legal filing requirements by yourself. While this can take a significant amount of time, it is undoubtedly a workable option for individuals with: excellent task initiative, high self-discipline, and robust organizational skills.
Can hiring an accountant save me money?
Yes, even though some accountants may appear to charge seemingly exorbitant prices (which can sometimes exceed $400 an hour), their specialized services commonly save business owners significant capital in a variety of ways. These include helping them to:
- Avoid tax penalties
- Increase their total annual savings
- Adequately organize any future expansion initiatives that they may be planning