Accounting Formulas

Accounting formulas and ratios are used to manipulate information so that accountants and other users of financial information can extract useful information to determine the health of a business.

It is really quite easy to predict a company's ability to survive. A quick examination of the financial statements can yield a treasure of important information. This information will tell you if the company is collecting its revenues in a timely manner and if it has too much debt and may not be able to survive a downturn in the economy. Also, it is quite easy to determine if a company is earning enough to stay in business.

Accounting formulas and ratios are used by investors to determine if their investment in a company is prudent. Also, financial audit firms will use these formulas to assess the company and make recommendations for improving the health of a company's finances.

Potential employees should also review the financial statements of a company to make a determination of whether the company will be around for a long time, and if it is profitable.

The most basic of accounting formulas is:

  • Assets = Liabilities + Owners Equity
Using algebra, we can make the following equations:
  • Liabilities = Assets - Owners Equity
  • Owners equity = Assets - Liabilities
This is the basic balance sheet accounting formula. All balance sheets of all businesses should be structured this way. The assets on the balance sheet must equal the liabilities of a company plus the owner's equity in the company.

Hand written accounting formulas illustration Ratios are used for quick analysis of financial reports. There are three main categories that ratios cover:
  • Liquidity

  • Profitability

  • Debt Management

Liquidity ratios try to determine if a company has enough cash to pay bills and remain solvent:
  • The current ratio is:

    • Current assets / current liabilities
    • The rule of thumb is around a 2 to 1 ratio

  • The quick ratio is:

    • (cash + marketable securities + receivables) / current liabilities
    • The rule of thumb is a ratio of 1 to 1

  • The receivable turnover is:

    • Sales / average accounts receivable
    • Each industry has their own rule of thumb

  • Inventory turnover:

    • Cost of goods sold / average inventory
    • Each industry has their own rule of thumb

Profitability ratios try to determine if the business is earning enough to stay in business, or if the money invested could earn more elsewhere:
  • Profit margin on sales ratio:

    • Net income / sales
    • Rule of thumb is 2% to 5%

  • Asset turnover:

    • Sales / average total assets
    • Measures sales produced compared to asset investment

  • Return on equity:

    • Net income / average owners equity
Debt management ratios:
  • Debt to equity ratio:

    • Total liabilities / owners equity
    • Rule of thumb is 1 to 1

  • Total debt to assets:

    • Total debt / total assets
    • Lenders like to see low debt ratios
    • To have a high debt ratio means the company is leveraged
Any examination of a company should also include items that can be found in the notes of the financial statements and the company's annual reports. First, is the company in a growth industry, or is the industry contracting? Second, are there future sales orders for the company? That is, is the company going to grow or shrink?

What is the company's competition doing? Is the competition expanding and creating new cost effective ways to operate? Is the economic climate of the country and the world favorable or unfavorable for this company?

With a deep analysis of a company's financial statements and annual reports, etc, a good opinion can be made as to whether this is a sound company that has potential future growth opportunity or whether it is unlikely to survive a downturn in the economy.