~by Courtney Barbee~
In Part 1 of this accounting article series, Why You Need to Know Your Business Financials, we discussed the importance of knowing how your company is doing financially, and provided three examples of business owners who drastically improved their finances simply through improving their understanding of them.
Now, in-depth accounting knowledge can take years of study and training to acquire. Fortunately, there are a few basic formulas you can use to get a snapshot of your company’s status. To build upon our car metaphor from the prior article: we aren’t trying to teach you to rebuild an engine, but we can show you how to check the oil.
1. Break-Even Point
Ideally, you should have an idea of your break-even point before your business ever opens its doors. As can be surmised from the name, your break-even point is how much you need to make in sales to “break even”, and can be calculated in units or dollars.
The first step in computing your break-even formula is to determine your total fixed costs, variable cost per unit, and unit price.
In case you are unfamiliar with the terminology, fixed costs are those that remain constant, such as mortgage and insurance costs. Variable cost per unit is how much you must spend to produce one additional unit, and might include materials and cost of direct labor. Unit price is, of course, how much you sell each item for.
The formula for break-even units is,
Fixed Costs / (Unit Price – Variable Cost Per Unit) = Break-Even Units
To determine break-even in sales dollars, you simply multiply Break-Even Units * Unit Price.
2. Accounts Receivable and Accounts Payable Turnover Ratios
These equations are two sides of the same coin. Accounts receivable (which we will henceforth refer to as A/R) and accounts payable (A/P) are, respectively, the amounts you are owed by customers and the debts you owe to vendors. You can use their turnover ratios to estimate how healthy your business’s cash flow is.
The first formula is the A/R turnover ratio. The figures you will need to know for this formula are your net credit sales (how many sales you have made on credit), and your average accounts receivable (average monthly ending A/R balance).
The formula for A/R turnover ratio is,
Net Credit Sales / (Average Accounts Receivable * 365) = A/R Turnover Ratio
The ratio indicates how many times a year you are collecting your average accounts receivable. (A higher number is better, as it shows you are being paid more frequently.)
A/P turnover ratio is calculated in a manner similar to A/R turnover ratio.
The formula for A/P turnover ratio is,
Total Purchases / (Average Accounts Payable * 365) = A/P Turnover Ratio
This formula helps determine your liquidity (or, ability to pay the bills).
Ideally, your A/R Turnover Ratio will be higher than your A/P Turnover Ratio, indicating that your customers are paying you more frequently than you are needing to pay outstanding bills.
3. Months Operating at Loss
It is an unfortunate fact that many small businesses are not always immediately profitable. In fact, it is highly common for new businesses to “run in the red” (operate at loss) for some time before turning the corner and building enough clients or market share in order to earn a profit.
However, knowing that this is a common problem does not ease the financial burden which is placed upon the business owners facing it. Building up cash reserves in advance can ease the strain of supporting a growing company. In this situation, it is helpful to know exactly how long a company can operate at a loss (or, specifically, with no revenues at all). To calculate this, you will need your monthly fixed costs (as tabulated for your break-even point in entry #1) and your total cash.
The formula for determining how long your company can operate at a loss is simply,
Cash / Fixed Costs = Months Operating Without Income
So, if you have $120,000 in cash reserves and monthly fixed costs of $20,000, you can keep your business open for 6 months with $0 in sales.
Though this does not replace extensive accounting analysis, awareness of these three basic formulas can help you keep an eye fixed on your company’s financial health.
Meet the Author: Courtney Barbee
Courtney works and writes for The Bookkeeper, a small business accounting and consulting company based in Raleigh, North Carolina.
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