Understanding how to measure efficiency is one of the first steps to ensuring your business is on the right track. Good financial literacy is key to understanding your company's financial statements.
You will find below all the terms and formulas needed to simplify your business financial journey as much as possible.
- Assets: Assets are virtually anything that your company owns that has worth, whether it’s tangible (real estate, a vehicle, machinery) or intangible (intellectual property such as patents). Assets have some tax ramifications, as they can appreciate or depreciate with time and be sold for cash.
- Balance Sheet: The balance sheet outlines specific aspects of your company’s financial situation, including assets, liabilities (such as debt), and equity.
- Cash Flow: How cash moves in and out of your business.
- Equity: The value of the shares issued by a company.
- Expenses: Any costs you absorb during operations — for example, rent, printing services, and employees.
- Liabilities: These are any debts outstanding. Typically, these are going to be loans, but they can also include accounts payable, debt on credit cards, or taxes you haven’t yet paid.
- Net income: Also known as profits or earnings, net income is what is left over when you subtract all expenses (including taxes and depreciation) from revenues.
- Income statement: This is the financial story of your business, showing how much you made and then listing the various expenses your business needed to incur along the way. Thus, it will include revenues, expenses and net income (or net losses).
- Return on investment: This refers to calculating what kind of profit was generated from a certain amount of investment. So, if you spent $500 on an ad campaign that you could tangibly determine delivered $1,500 in net income, the return on investment for that ad campaign was 200%.
- Current Ratio: The company's current assets are divided by its current liabilities. The current ratio measures a company's ability to pay its bills on time. For example, if your current ratio is near or below 1, your business could be in jeopardy of being unable to pay its creditors, and it might be time to raise more capital. On the other hand, too high a current ratio means you might have capital going unused, and you should consider investing more in long-term growth.
- Inventory Turnover: This refers to the number of times inventory is sold and replaced within a given period. It is calculated by dividing the average inventory per period by the cost of goods sold. A rapid turnover enables a company to earn lots of money without spending significantly on building inventory.
- Gross Margin: Gross margin is simply gross profit divided by revenues, and it measures the difference between what you can sell your product for and how much it costs to make. Gross margin is all about the efficiency of your operation and the effectiveness of your pricing strategy.
- Return on Invested Capital: ROIC is the most crucial measure of the long-term profitability of your business. ROIC is calculated by taking the after-tax operating profit of your business and dividing it by invested capital (total assets minus excess cash and non-interest-bearing current liabilities). Since ROIC is based on profits, it's not an aspect that businesses in their early growth stages will be looking at too closely. More profit with lower capital means more money the company can return to shareholders, i.e. you and/or investors.
Now that you have a general overview of key accounting terms, let's take a look at essential formulas:
1- The Accounting Equation:
Liability + Equity = Assets
2- Net Income:
Revenues – Expenses = Net Income
3- Break-Even Point:
Fixed Costs / (Sales Price Per Unit – Variable Cost Per Unit) = Break-Even Volume
4- Cash Ratio:
Cash / Current Liabilities = Cash Ratio
5- Profit Margin:
[ (Revenue - Cost) / Revenue] *100 = Profit Margin
6- Debt-to-Equity Ratio:
Total Liabilities / Total Equity = Debt-to-Equity Ratio
7- Cost of Goods sold
Starting Inventory + Purchases – Ending Inventory = COGS
8- Retained Earnings:
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