Accounting Equations Your Small Business Needs to Know
Stop me if you’ve heard this one:
“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
That’s a very popular quote—allegedly about the Rule of 72—attributed to a fellow named Albert Einstein. While recent evidence has proven that Einstein didn’t actually come up with the equation (or even the quote, for that matter), the fact remains that the rule of 72 is an invaluable tool for accountants and investors.
The rule of 72 is one of several accounting equations that anyone dealing with investments might already know, but what many don’t know is that there is accounting software available to help simplify these processes.
Consider what Ginger Bradfield, the financial manager at McKinney York Architects in Austin, Texas, had to say about the value accounting software can offer to SMBs:
“The greatest gain from migrating to software with automated accounting functionality was a dramatic decrease in opportunities for error. We’re also able to enjoy other benefits such as real-time cost information and customizable reporting tools, all while saving countless hours of labor by streamlining these processes.”
Ginger Bradfield, Financial Manager at McKinney York Architects
Here are the equations we’ll cover in this article:
The Accounting Equation
In discussing various accounting equations, we’d be remiss if we overlooked the one that has been so highly regarded as to earn this title. The formula is most commonly written out as follows:
Assets = Liability + Owner’s Equity
Other variations of the same equation are:
Liabilities = Assets – Owner’s Equity
Owner Equity = Assets – Liabilities
In all of the above equations, “Assets” refers to everything your company owns, including things like property and inventory. “Liability” represents any cost you must pay, such as insurance premiums, and “Owner’s Equity” is simply the value of the company that you own outright.
Essentially, the Accounting Equation is designed to show which of a business’s assets are provided by creditors and which are provided by owner(s). Typically, this information will be displayed in a balance sheet.
EXAMPLE: Marilyn is the sole owner of a clothing boutique in Denver. She has put $100,000 of her own money into the business to purchase the products she keeps in stock, but she does not own the property in which her store is located. Instead she pays $2,000 in rent each month.
This is how Marilyn would calculate her assets for a 12 month period:
Assets = ($2,000 x 12 months) + $100,000
Assets = $24,000 + $100,000
Assets = $124,000
Software Features to Help Leverage the Accounting Equation
Fixed asset or asset tracking software will generally be best equipped for this kind of functionality. Designated asset tracking features allow users to input dollar amounts in specified fields, then takes those amounts and keeps a running calculation going so users can view their assets in real time at all times.
Fixed asset isn’t your only option for functionality to help with this equation, though. Any core accounting software with a robust reporting tools will make calculating your business’s value easier.
One thing you want to look for specifically when researching reporting tools will be balance sheet capabilities. You may want to consider balance sheet software that allows you to select date ranges, choose specific departments, compare balance sheets over the years, customize layouts and view summarized versions.
The Break-Even Point
Break-Even point analysis is used to determine how much revenue a business must earn in order to cover all expenses during a specific time period. While it’s usually used to find dollar amounts (or other currencies, depending on where the business is operating), revenue can be represented in this equation as other units such as hours of services rendered.
The formula for break-even point is this:
Break-Even Volume = Fixed Costs / (Sales Price – Variable Cost Per Unit)
In this equation, “Fixed Costs” are all of the normal, expected costs of running a business—anything from rent to salaries. “Sales Price” refers to the price at which you sell your goods or the amount you charge for your services, however you standardize that amount.
“Variable Cost Per Unit” is amount you have to spend to make your product or provide your service.
EXAMPLE: Daniel runs a food truck in Florida that specializes in grilled cheese sandwiches. He has one employee who earns a salary of $35,000 in a year, and he has to pay $150 each month for insurance.
Factoring in ingredients and labor, it costs Daniel $1.90 to make one grilled cheese sandwich, but he charges patrons $5.75. So:
BE Volume = (($35,000 / 12) + $150) / ($5.75 – $1.90)
BE Volume = $3,067 / $3.85
BE Volume = 797
Daniel must sell at least 797 grilled cheese sandwiches each month to cover his costs.
Software Features to Help Leverage the Break-Even Point Equation
Once again, robust reporting tools will win the day when it comes to making equations easier. Users are going to want to keep an eye out for core accounting software that includes customizable Profit & Loss reports to simplify this calculation.
Some vendors provide interactive spreadsheets that let managers play with the numbers to figure out how much they need to charge for their product in order to impact the rest of the business.
Profit margin is a logical next step after calculating your Break-Even point. The latter tells you when you earn back what you’ve put into your business, and the former tells you how much revenue beyond that point is, well, profit. Here’s the formula:
Profit Margin = Net Income / Sales
In this equation, “Net Income” is equal to the amount your business has made less expenses, and “Sales” indicates the balance of every sale you’ve made.
Calculating revenue and profit margins can help you determine how well your company is doing and make adjustments. For example, you can use this formula to help set prices for goods or services in order to modify your earnings and better cover the cost of manufacturing or shipping.
**EXAMPLE:** Terry is working on calculating the total profit margin for her book store at the end of the year. She brought in $400,000, but had to pay a total of $25,000 in rent, $15,000 for insurance and $150,000 in salaries for her six part-time employees. Therefore:
PM = ($400,000 – $25,000 – $15,000 – $150,000) / $400,000
PM = $333,000 / $400,000
PM = 5.2%
Software Features to Help Leverage the Profit Margin Equation
When it comes to software that can help you know and manage your profit margin, it might be useful to broaden your search.
While accounting software typically generates a good overview of your expenses through automatically updated dashboards, P&L reports and asset tracking, project management software can help you break down your time and spending even further through analytic functionality.
The Bottom Line
At the risk of oversimplifying or generalizing these complex and vital business equations, it all comes down to reporting and tracking. To run any kind of analysis on your finances, you have to have the numbers to plug into the equation.
The most important thing to consider when searching for software that will help you with all of these business equations is going to be the level of customization available in reporting tools and the level of detail available in tracking tools.
If you have any questions about this information, or if you’d like to learn more about accounting software solutions for your business, email me at firstname.lastname@example.org.