Accounting is basically how a business records, organizes and interprets its financial information, which is derived by the use of 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 be able to pass your exams and later do your job. Also, it’s important that you know the formulas as well as how to interpret the results – in this article, we have covered it all for you!
By default, some of the accounting calculations are more important than others in gauging the health of the business. The 5 most important 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 key 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 want 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the business's current owners an indication of how much is available to reinvest in the business and how much can be withdrawn to distribute among ordinary and preference shareholders.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 is unable to 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 are unable to 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 huge monetary losses for the business.
In addition, during the time a business is holding this inventory, it is incurring 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 there is substantial demand for their products. A low inventory turnover may indicate weak sales and low demand for the business's products. It is said that for retail businesses, an inventory turnover ratio between 2 and 4 is considered good.
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 core operations of the business.
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. The Indirect Method on the other hand reconciles profit before tax to cash generated from operating profit.
Operating cash flows formula, using the direct method, at its simplest can be said to be as follows
The operating cash flows formula, using the indirect method, at its simplest can be structured as follows. Depreciation and impairment charges are some of the 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.
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 the degree to which a business is financing itself through debt and equity. An optimal debt-to-equity ratio is considered to be 1:1. However, in reality, 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, the first ones to be paid are secured creditors. These are followed by unsecured creditors which include but are 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 in the development of a viable financial strategy. Keeping an eye on the debt and equity ratio will help the business come up with 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, in reality, it is likely to vary from industry to industry.
5) Current Ratio
Current Ratio = Current Assets/Current Liabilities
The current ratio is a vital ratio that is used by various lending institutions and investors to assess the liquidity of a company. It reflects how efficiently a business can pay off its day-to-day liabilities with the current assets it has.
Current assets are liquid assets that a company can hope to convert into cash within a year. Some of the current assets are cash, inventory and receivables. Current liabilities are liabilities that a business expects to pay within a year’s time. These include some payables and bank 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 the credit scores of customers before selling them on credit. A high level of payables may suggest 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 ratio of current assets to current liabilities should be higher, which is termed as “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.