Accounting is basically how a business record, organises and interprets its financial information, which is derived by using a set of formulas and represented in a way that’s easy for decision-making.
So, if you’re an accounting student going to become a finance or accounting professional, there is a set of formulas that you must know to pass your exams and later do your job. Also, you must understand the formulas and how to interpret the results – in this article, we have covered it all for you!
By default, some accounting calculations are more important than others in gauging the business’s health. The 5 most essential formulas in accounting are based on the three key financial statements:
- Statement of profit and loss and other comprehensive income
- Statement of financial position
- Statement of Cashflows
1. Net Income/Net Profit
Net Income = Total Revenues – Total Expenses
Net income refers to the amount of profit a company has made after deducting all relevant expenses. Sustainable net income is a crucial metric that investors and lenders are most interested in.
Investors want to know whether the business will generate returns for them in the long term, while the lenders wish to assess the business’s ability to pay back its borrowing on time.
Net income also gives the business’s current owners an indication of how much is available to reinvest in the business and how much can be withdrawn to distribute among ordinary and preferred shareholders.
Net income calculation can be broken down into two parts:
- Gross profit
Gross profit is calculated by deducting the cost of sales from the revenue.
- Operating profit
Operating profit is calculated by deducting operating expenses from the gross profit.
2. Inventory Turnover Ratio
Inventory Turnover = Cost of Goods Sold/(Average or Closing Inventory)
The inventory turnover ratio indicates the ability of a business to turn inventory into cash. A business often has large sums of money tied up in the inventory. If it cannot sell this inventory, it will find itself unable to pay its creditors, unable to reinvest in the business and will find itself in financial turmoil.
Furthermore, if they cannot sell their inventory, a business may find itself saddled with goods that are getting obsolete or damaged with time – goods that it can possibly no longer sell. This will imply substantial monetary losses for the business.
In addition, when a business is holding this inventory, it incurs the opportunity cost of valuable warehouse space that it could have used for other business operations.
In general, the higher the inventory turnover ratio, the better. A high inventory turnover ratio indicates that the business is making good sales and substantial demand for its products. A low inventory turnover may mean weak sales and low demand for the business’s products. An inventory turnover ratio between 2 and 4 is considered good for retail businesses.
For some businesses with high-profit margins, such as jewellers or merchants selling antiques, a lower inventory turnover ratio is likely to be acceptable, while for businesses such as grocery stores, this ratio is expected to be much higher,
3. Operating Cashflows
It cannot be refuted that cash is the lifeblood of a business. A business with insufficient cash flow is destined for failure. Operating cash flows reflect the vitality of the business and reflect the cash generated from the business’s core operations.
Operating cash flows can be calculated using the Direct Method or Indirect Method. The Direct Method is where payments made to employees and suppliers are deducted from receipts from customers. On the other hand, the Indirect Method reconciles profit before tax to cash generated from operating profit.
The operating cash flows formula, using the direct method, at its simplest, can be said to be as follows.
|Cash receipts from customers||xxxx|
|Cash paid to suppliers||(xxxx)|
|Cash paid to employees||(xxxx)|
|Cash paid for other operating expenses||(xxxx)|
|Income tax paid||(xxxx)|
|Net cash from operating activities||xxxx|
The operating cash flows formula, using the indirect method, at its simplest, can be structured as follows. Depreciation and impairment charges are items that can be included under non-cash expenses. Meanwhile, changes in the values of receivables, payables and inventory would come under the head of an increase in working capital.
|Profit before tax||xxxx|
|Add: impairment charges||xxxx|
|Increase in receivable||xxxx|
|Decrease in inventories||xxxx|
|Increase in trade payables||xxxx|
|Income taxes paid||xxxx|
|Net cash from operating activities||xxxx|
4. Debt-to-Equity Ratio
Debt-to-Equity = Total Liabilities/Total Shareholders’ Equity
The debt-to-equity ratio is an important financial metric because it reflects how a business finances itself through debt and equity. An optimal debt-to-equity ratio is considered to be 1:1. However, the optimal ratio is likely to vary from industry to industry.
It is essential to understand the importance for the business of drawing a balance between its debt and equity financing. Let’s start with the creditor hierarchy. When a company goes into insolvency, secured creditors are the first ones to be paid. These are followed by unsecured creditors, including but not limited to the company’s employers and suppliers. The final ones to be paid are the stockholders of the company.
Even within the stockholders, preference shareholders get paid first. The last ones to be paid are the ordinary shareholders, which are left to bear the brunt of the company’s misfortune.
The more debt a company has, the lesser the likelihood that its various lenders and investors will get anything if the company becomes insolvent. Hence, this is a key metric that institutions look at before lending to a business.
It is also an important metric for the business itself to develop a viable financial strategy. Keeping an eye on the debt and equity ratio will help the business develop a financing strategy that best balances its level of debt and shareholders’ equity.
An optimal debt-to-equity ratio is considered to be 1:1. However, it is likely to vary from industry to industry in reality.
5. Current Ratio
Current Ratio = Current Assets/Current Liabilities
The current ratio is a vital ratio used by various lending institutions and investors to assess a company’s liquidity. It reflects how efficiently a business can pay off its day-to-day liabilities with its current assets.
Current assets are liquid assets that a company can hope to convert into cash within a year. Some of the existing assets are cash, inventory and receivables. Current liabilities are liabilities that a business expects to pay within a year. These include some payables and bank accounting overdrafts.
The current ratio also reflects a company’s ability to manage its current assets. A high level of receivables may suggest poor receivable management policies, such as not checking out customers’ credit scores before selling them on credit. A high level of payables may indicate an inability on a company’s part to pay off its debts as and when they arise.
It is often agreed that a current ratio of 1:1 is not always sufficient. Ideally, the proportion of current assets to current liabilities should be higher, termed the “margin of safety”. A current ratio can also be sometimes considered too high. Investors want the current ratio to be high but do not want the business to tie up their money excessively and unreasonably in stocks.