In an ideal world, you could pay equal attention to every aspect of your small business. But more likely, you’ll have to focus on certain tasks and delegate others to keep things running smoothly. For instance, accounting can be a complicated field, and most of that work can be outsourced to accounting software or a professional. However, learning some basic accounting for small business operations can help you measure your performance and make better decisions for the future, even if your accountant handles the books.
To save you from cracking open a textbook, we outlined the most useful accounting terms and equations you’ll find on your financial statements.
Cost of Goods Sold
Equation: Cost of Goods Sold (COGS) = Beginning Inventory + Additional Purchases – Ending Inventory
Calculating your COGS will show how much you’re spending to produce your product or services. This includes the cost of buying raw materials, wages to build your product, and the cost to buy inventory directly from a supplier.
Let’s say a company sells bikes. At the beginning of the month, they have $50,000 worth of inventory. During the month, they resupplied with an extra $10,000 of inventory. At the end of the month, they have $20,000 of inventory left.
Their COGS = $50,000 + $10,000 – $20,000 = $40,000
You need the COGS to calculate your profit, covered next. Knowing your COGS can also improve your bottom line, as lowering your COGS will help you generate more positive cash flow for the same amount of sales.
Equation: Net Profit = Total Sales – Total Expenses
To calculate your net profit, you’ll need to add up your total expenses first, which includes your COGS and other operating costs like overhead.
The bicycle shop had $60,000 in monthly total sales and their COGS was $40,000. They also paid $10,000 that month for overhead expenses like rent.
Their net profit = $60,000 – $40,000 – $10,000 = $10,000
If they can negotiate a better deal with their supplier and lower their COGS, their net profit would go up. For additional accounting terms, you may also hear about gross profit, which is your total sales minus the COGS. It doesn’t subtract the other operating costs.
Net Profit Margin
Equation: Net Profit Margin = Net Profit ÷ Total Sales
The bicycle shop had a net profit of $10,000 and total sales of $60,000.
Their net profit margin = $10,000/$60,000 = .167
To change the figure to a percentage, multiply it by 100.
.167 x 100 = 16.7%
When you know your profit margin, you can compare it against the industry average to see how you’re doing. This Stern NYU spreadsheet outlines the net profit margin across industries. If your margin is above average, you’re doing a better job than your competitors at controlling costs, while a below average margin means you could potentially run your business more efficiently.
Balance Sheet Equation
Equation: Assets = Liabilities + Equity or Equity = Assets – Liabilities
Let’s move beyond sales to look at some other business finance terms found on your balance sheet. The balance sheet has three parts:
- Assets: what your business owns
- Liabilities: what your business owes
- Equity: the value of the company to you and the other owners
By increasing the value of your business assets or paying off your debts, you then increase the overall value of the company for yourself when (or if) you decide to sell.
The bicycle shop has $1 million in assets when you add up the value of their building, equipment, vehicles, tools and unpaid customer invoices (accounts receivables). They currently have a $400,000 bank loan and owe $100,000 to their suppliers.
Their equity = $1 million – $400,000 – $100,000 = $500,000
Their business would be worth $500,000 if they had to sell everything off.
Equation: Debt-to-Equity Ratio = Total Liabilities/Total Equity
A high debt-to-equity ratio is a sign of risk because a business has borrowed heavily to support its operations. According to HubSpot, a good debt-to-equity ratio is 1 to 1.5, though the figure can be higher depending on the industry. If your debt-to-equity ratio is outside this range, it could create another potential obstacle for getting a business loan.
For the bike shop, their debt-to-equity ratio = $500,000/$500,000 = 1.
If you don’t handle your own books, that’s OK. Learning some basic accounting for small business operations will still be helpful, especially when reviewing financial statements. You’ll gain valuable insight, and may even be able to impress your accountant at your next meeting.