When evaluating your company’s performance, it helps to dig into the financial statements and understand the numbers. But with 23% of business owners feeling anxious about their accounting skills, according to an Intuit survey, a lesson in basic accounting terms for small business owners can go a long way.
In a previous post, we started with some of the most common accounting equations for small business owners. With those under your belt, let’s check out a few more basic accounting terms that are just as useful.
Return on Investment (ROI)
Equation: ROI = (Investment gain – investment cost)/Investment gain
The return on investment formula shows what you’d earn from a certain project or initiative relative to the costs. This formula can help you compare different projects and find the best use for your money.
Let’s say a restaurant owner is considering opening a new location. She doesn’t want to open a branch unless she sees a 25% return on her investment. She estimates that a new location would earn $500,000 but would cost $400,000 to open.
ROI = ($500,000 – $400,000)/$500,000 = $100,000/$500,000 = 0.2 = 20%.
While the new location is profitable, it won’t earn quite enough to meet the business owner’s goal of a 25% return, so she doesn’t move forward.
Equation: Break-even point = Monthly fixed costs/(Sales price per unit – variable cost per unit)
With this equation, you can tell how many sales you’d need to make in a month to cover all your fixed and variable costs.
For example, a chair manufacturer pays $100,000 per month in overhead for fixed costs like rent, salaries and insurance. They sell each chair for $100. However, production costs $30 per chair for materials, electricity and transportation.
Their break-even point = $100,000/($100-$30) = 1,429. They need to sell at least 1,429 chairs each month to cover their costs.
Equation: (Cash + cash equivalents)/short-term liabilities
With the quick ratio, you can tell if you have enough money on hand to cover your upcoming bills, or if a cash crunch is around the corner.
In this equation, you add up all your cash along with any assets that can quickly be turned into cash without losing value. You then divide this by your short-term liabilities, which are bills you need to pay within the next fiscal year.
For example, a construction firm has $50,000 in cash. They also have $200,000 in unpaid invoices that they should collect on within the next 90 days. They expect to owe $200,000 to their creditors and other bills over the next fiscal term.
Their quick ratio = ($50,000 + $200,000)/$200,000 = 1.25
Ideally, your quick ratio would be at least 1 or higher because that means you have enough cash to cover all your bills. A ratio of less than 1 means you may not have enough cash to cover your upcoming bills, and may have to consider a short-term business loan.
Equation: Inventory shrinkage = (Recorded inventory – actual inventory)/recorded inventory
In a perfect world, you would sell 100% of your inventory. But in reality, some items will break, get stolen or just become obsolete and need to be thrown away. The inventory shrinkage formula shows what share of your products end up lost to these causes.
Let’s say the owner of a clothing store goes over his inventory of pants. Based on his last order and sales, he should have 300 left but in reality, he only has 290.
His inventory shrinkage = (300-290)/300 = 3.33%
By tracking this figure over time, you can get an idea what your shrinkage should look like under normal situations so you can catch the problem early. If your shrinkage rate shoots up, someone could be stealing inventory.
Even if math isn’t your favorite, a lesson in basic accounting for small business owners can help you make more strategic business decisions. Between these formulas and the five others from our previous piece, you’ve got all the basic accounting terms covered. All that without cracking a textbook.