Business owners typically learn quickly that not only do they need to have expansive knowledge of their products and services, but they need to be well-versed in basic business management as well. Whether you manage your own business finances
or outsource your accounting needs, you should have a solid understanding of the most critical financial benchmarks for your business.
Being familiar with basic accounting formulas and knowing how to calculate them will allow you to better track the financial health of your company. There are a wide range of business calculations, and industry-specific metrics as well, but here is an overview of four of the most important formulas for business owners to know:
1. Balance Sheet Equation
The most basic formula to know as a business owner is the balance sheet equation. No matter what industry you are in or how much revenue you’re making, the balance sheet equation is critical for gaining a high-level understanding of how business is going. The balance sheet equation is as follows:
Assets = Liabilities + Equity
Assets refer to the things your company owns, including equipment, inventory, cash, property, and accounts receivables. Liabilities refer to any outstanding debts and payments the business must make. Equity is the portion of the business that is owned outright. If the business has one owner it is commonly called “owner’s equity”, and if the business has multiple owners, it’s referred to as “shareholder’s equity”. Either way, equity generally represents the true dollar value of your business. The higher your business’s equity, the stronger the business is operating from a financial standpoint.
2. Profit Margin
Profit margin is a measure of your business’s profitability. It is the percentage of revenue that your business actually keeps after expenses are deducted. This calculation is vital for determining the health of your company. Profit margin can be calculated on a per-product or per-service basis, or you can calculate it for your business as a whole. The two most popular ways to calculate profit margin are “gross profit margin” and “net profit margin”. Gross profit margin is the simpler of the two, and only takes into account one expense: the cost of goods. Net profit margin, on the other hand, takes into account all of your expenses. Let’s take a closer look at both:
Gross Profit Margin: Gross profit margin can be calculated as follows:
(Revenue – Cost of Goods) / Revenue x 100
For example, let’s say you were calculating the gross profit margin of a bicycle. If your business sold the bike at a retail price of $100, that would be the “revenue”. If you paid $75 to get the bike into your store as inventory, that would be the “cost of goods”.
(100 – 75) / 100 = 0.25
0.25 x 100 = 25%
So, in this example, the bike has a gross profit margin of 25%.
Net Profit Margin: Net profit margin can be calculated as follows:
Net Income / Revenue x 100
In some cases, you’ll want a more accurate profit margin calculation that takes into account more expenses than just your cost of goods. Net profit margin accomplishes this by using net income instead of revenue minus cost of goods. Net income is your revenue minus all expenses, including your cost of goods, operating expenses, interest expenses on your outstanding debts, and taxes owed.
So, if your company’s revenue for the last year was $250,000 and your total expenses were $180,000, your net profit margin would be 28%:
$250,000 - $180,000 = $70,000 (in other words, net income)
$70,000 / $250,000 = 0.28
0.28 x 100 = 28%
Both of these calculations can help you to determine if you are pricing your products and services correctly, or if you need to cut back on your overall expenses in general. Knowing how to calculate profit margin is vital for business owners as it can help you determine the financial health of your business, alert you to areas of opportunity, and enable you to recognize pricing issues you may have been unaware of. You may also need to demonstrate your profit margin in order to secure financing for your business. Just remember that a healthy profit margin may look different across different industries.
3. Year-Over-Year Growth
Another formula that is important for business owners to know is year-over-year growth. This will help you determine if your business is growing as expected.
Determining year-over-year growth is a simple formula. Start by subtracting the previous year's revenue from the current year’s revenue. You then take that figure, divide it by last year's revenue, and multiply by 100 to get the percentage.
For example, if you took in $500,000 in revenue in 2020, and $575,000 in 2021, your year-over-year growth formula would look like this:
$575,000 - $500,000 = $75,000
$75,000 / $500,000 = 0.15
0.15 x 100 = 15%
So, in this example, your revenue grew 15% year-over-year.
Your year-over-year growth rate can show if your business is making steady progress. It can also be more useful than comparing quarterly or monthly performance, which may ebb and flow, especially if your business is seasonal.
4. Debt-to-Equity Ratio
Liquidity is extremely important to business owners. Calculating your debt-to-equity ratio can help you determine how much liquidity your company truly has. This means how quickly or easily your assets can be converted into cash. On-hand cash is considered your most liquid asset, while tangible items are less liquid because they have to be sold in order to get cash.
To calculate your business’s debt-to-equity ratio, take the sum of your liabilities (such as outstanding loan and credit card balances), and divide that number by your total equity (see formula number 1 above for more information on determining your business’s equity). For most industries, a good debt-to-equity ratio is 1 to 1.5. Anything higher could be a sign of poor company stability. Generally, the lower your debt-to-equity ratio, the more stable your business will appear to be, especially to lenders. High debt-to-equity ratios could be a red flag to creditors and might even scare off prospective investors, as it could signify a risk.
By understanding common business equations and how to calculate them, you can better understand the health of your business. If you are a business owner in MA or RI and looking for solutions to help increase efficiency, or seeking financing for cash flow or expansion, don’t hesitate to schedule a free consultation with a member of our Business Banking team today.