“Having a basic understanding of bookkeeping is crucial, especially when juggling multiple suppliers, clients, invoices and payment terms,” says Andy Weatherby, owner of mechanical engineering business, A. Weatherby Contracting. For Weatherby, carefully-managed finances breed stable, well-run operations and are the key to growth.
In this article, we detail seven essential accounting formulas that every business owner should know.
What is an accounting formula?
Accounting formulas are used to evaluate the finances of an organisation and can be used as frequently as necessary to get a clear picture of business performance. They can be as simple as cash in versus cash out, or more complex, taking into account variables such as debts, assets, depreciation, equity and liabilities.
No matter what stage a company is in, there are seven accounting formulas that business owners should know to get a clear picture of their business’ health, and the path to more significant profit.
1. Cost of goods sold formula
Businesses selling a product or service need to know the cost of creating those products during any period of time. The cost of goods sold formula (COGS) can also be used to set prices, calculate net income and work out if profit margins are too low.
Starting Inventory + Purchases - Ending Inventory = Cost of Goods Sold
The most important factor when calculating COGS is to have a clear and consistent approach to valuing the inventory and accounting for the cost of sales.
"Out-of-date variables cause fluctuations, so revisit and rerun the formulas,” says Rick Smith, managing director at Forbes Burton, an insolvency and business rescue specialist. “With the current global uncertainty, regular reruns of formulas over short time periods is a good strategy.”
2. Variable cost formula
Variable costs are the costs incurred to create or deliver each unit of output. Along with fixed costs, variable costs can be calculated to understand the total expenses of a business.
Cost Per Unit x Total Number of Units = Total Variable Costs
One advantage of having a clear view of variable costs is they can be adjusted quickly. If a company is experiencing cash flow struggles, it could alter production to make necessary cutbacks.
3. Working capital formula
Working capital is calculated by subtracting current liabilities from current assets such as cash, accounts receivable and inventory. Current liabilities include accounts payable, taxes, wages and interest owed.
Current Assets - Current Liabilities = Working Capital
Understanding how working capital is calculated is one of the fundamentals of running a business, says Clive Pacey, an accounting expert and founder of CPCM Finance.
“The working capital formula is a snapshot of your liquidity,” says Pacey. The more positive the ratio in favour of total assets, the better. Within the calculation, the assets and liabilities can be graded according to their urgency (liabilities) and accessibility (assets), Pacey adds.
Positive working capital allows a company to pay its bills and invest to meet business demand. Good working capital management allows business owners to meet their daily running costs while using resources in the most efficient way.
4. Working capital cycle formula
The working capital cycle formula is about having funds to cover wages or vendor fees and similar within a given timeframe (the cycle). A business’ working capital cycle is the length of time it takes to turn net working capital, like current assets and liabilities, into cash.
Inventory Days + Receivable Days - Payable Days = Working Capital Cycle
“There came a point where I was landing larger contracts and I had to think about being smarter with my cash flow,” says Weatherby, whose business now handles clients across the UK. “I might have to rent a specialist drill or pressure test kits, paying thousands upfront each month, while the contract terms mean I won’t see a penny for 90 days.
"That’s often where the Amex Card comes in.”
The American Express® Business Gold Card has an extended payment window. With up to 54 days¹ until payment is due, Weatherby has more time to prepare for, and deliver on, contracts that have variable payment terms before the cost of specialist equipment has to be met.
To manage the cycle, Weatherby completes jobs as quickly as possible, ensuring he can collect revenue from customers on time. To optimise his cash flow during this period, Weatherby takes the full window to pay bills, completing the working capital cycle.
5. Cash flow formula
Cash flow equations boil down to ensuring a business is bringing in more money than it spends, leading to a sustainable, profitable operation. When things go the other way, and more money is flowing out of the business than in, trouble can arise.
Total Cash Inflows - Total Cash Outflows = Cash Flow
It can seem like a reasonably basic accounting equation formula, but there is more than meets the eye when applying cash flow equations to different types of financial transactions.
Some businesses only use the cash flow equation when tracking core business activities, for example, sales, as this is a form of direct cash flow, while others also include income from other sources, such as interest, or investment dividends.
6. Gross profit formula
Gross profit is revenue minus the cost of providing goods or services sold and is a handy metric to determine how effective a company is at manufacturing and delivering its products and/or services.
Revenue - Cost of Goods Sold = Gross Profit
The gross profit formula also helps to calculate net profit, revealing how effective a company is at turning its resources into profits. Usually, only variable costs are included in the cost of goods sold when calculating gross profit.
7. Operating profit formula
Operating profit is the total income earned after subtracting from revenue items like operating costs, COGS, and other expenses including depreciation (the expensing of a fixed asset over its useful life) and amortisation (the spreading of an intangible asset's cost over its useful life).
Revenue - Operating Costs - Cost of Goods Sold - Other Day-to-day Expenses = Operating Profit
Taking all these expenses together and setting them against gross income paints a clear portrait of profitability potential and identifies where any changes need to be made to bolster profits. Businesses with a higher operating profit are generally viewed as low risk, making them more attractive to investors.
“The golden rule to any of these formulas is using accurate data,” says Smith. “What you put in determines what you get out. Double check the route of the source data and spend the time to get it right from the start.”
1. The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
