You don’t have to be an accountant to be an entrepreneur — but it does help to have financial savvy. As the leader, you have more responsibilities than hobnobbing with investors and saying “yes” or “no” to logo designs. You control when and where the money goes, and you make plans for getting more money to help the business succeed. If you relax on your financial duties, your business will likely come crashing down around you.
Fortunately, startup accounting isn’t terribly complex. In fact, you only need to know a handful of formulas to keep your finances in check. Until your business is large enough to warrant a true accounting department, here are a few simple equations to use when you look into your business’s money matters.
The Accounting Equation
It is always useful to know what your business owns. That’s why this invaluable equation is named after a business’s most useful financial worker. The accounting equation helps you determine the worth of your assets using key figures you should have on hand:
Assets = liability + owner’s equity
You might know how much raw revenue your business is generating, but without this equation, you likely have no idea how much income you have available to reinvest in your business. Undoubtedly, new businesses have negative net incomes (read: losses) for some time; however, if your net income is negative for more than a few years in a row, you need to revisit your business plan.
Revenues – expenses = net income
Your net income is a useful figure to have because it tends to factor into other equations — like this one. Your profit margin represents the health of your business: A high profit margin is triumph and a low profit margin is disaster. Usually, low profit margins indicate some wonky numbers in your net income, which is worth investigating sooner rather than later.
Profit margin = net income / sales
Initially, your business goal should be to break even, which occurs when your income covers all of your costs. To calculate this point, you need to know how much it costs to make each product you sell, how much you sell your products for, and your fixed costs, like your office rent, employee salaries, and insurance premiums.
Break-even volume = fixed costs / (sales price – variable cost per unit)
Cost of Goods Sold
If you aren’t sure how to evaluate your variable cost per unit in the previous equation, you might make good use of the cost of goods sold formula. Business taxes often require exact numbers for cost of goods sold, so it’s smart to get familiar with this equation:
Cost of goods sold = Beginning inventory costs + additional inventory costs – ending inventory costs
Debt Service Coverage Ratio
Also called the debt coverage ratio, the debt service coverage ratio is the number lenders use to determine how much cash a business has to pay back loans. Essentially, if you are planning to obtain a small-business loan sometime soon, knowing your DSCR is vital. You can be your own debt service calculator with this formula:
DSCR = Annual net operating income + depreciation and other non-cash charges / interest + current long-term debt maturities
Another equation lenders use to evaluate your fitness for additional loans is the debt-to-equity ratio. This equation reveals what proportion of your business is funded from outside sources, like loans, and how much of it you own outright.
DER = total liabilities / total equity
Generally, the higher the cash ratio, the healthier the business. This is because your business’s cash ratio represents its ability to pay off its debts using cash. There are a few other ratios that factor other assets into liability payments, such as the current ratio or the quick ratio, but the cash ratio is simple enough for business finance beginners.
Cash ratio = cash / current liabilities
It’s a waste of time — and therefore a waste of money — to hold onto assets longer than you need to. If your money is tied up in assets, you can’t reinvest in your business to help it grow. Thus, the asset turnover formula is useful for understanding how quickly you can make sales.
Asset turnover = sales / assets