What is Accounting?
Accounting involves tracking and keeping a record of the financial transactions of an organization. Multiple functions build accounting into what it is, which are classifying, summarising, verifying, interpreting, recording, etc. data related to the finances of that particular institution.
From the viewpoint of an organization, it should be noted that accounting also deals with profits and losses incurred due to the trading of goods and services. Additionally, it also keeps records of assets and liabilities for a company.
Naturally, the data relating to accounting is represented in numbers, and deriving the right conclusion from an interpretation requires the proper use of the accounting formula. You should note that these formulas are the foundations of accounting. To build a stronghold on accounting and indulge in higher studies relating to accounts, you need to grasp the methods right from their grassroots.
Here is a detailed analysis of accounting and its formulas that are important in studying accounting.
What is an Accounting Formula?
To assess the functioning of a small business or even a large one, there is a set of specific accounting equation formulas that is most handy. They can be used as first-hand solutions to derive a conclusion depending on the business needs.
The formulas are listed below for your convenience.
Current Ratio = Current Assets/ Current Liabilities
Net Income = Income - Expenses
Cost of Goods Sold = Opening inventory value + Purchases of inventory – Closing inventory value
Gross Profit = Sales - Cost of Goods Sold
Gross profit Margin = Gross Profit/ Sales
Break-Even Point = Fixed costs / (Sales per unit cost - Fixed cost per unit)
Inventory Turnover Ratio = Costs of Goods Sold/ Inventory
Accounts Receivable Turnover Ratio = Sales on Credit/ Accounts Receivable
Quick Ratio = (Current Assets - Inventory)/ Current Liabilities
Return on Assets = Net Income/ Average Total Assets
Return on Equity = Net Income/ Average Shareholder’s Equity
Merely learning these formulas is less likely to be effective in dealing with numerical that are included under this topic. Therefore, a student has to build the basics of all these terminologies to tackle numerical and advanced concepts.
Understanding the Concepts
Let us understand some essential terms included in the accounting formula that is given below.
Income or Revenue
The cash inflows to a company or business are considered under revenue.
Expenses
The expenditure that is related to conducting production and sales activities is categorised under expenses.
Fixed Costs
Regular expenses that are incurred in a business to keep it functioning despite the productivity level, such as building rent and warehouse maintenance.
Variable Cost
Costs or expenses that differ based on the sales volume or productivity of business are variable.
Sales Price
It is the retail price at which a company or business sells its products or services to the public.
Current Assets
Assets that are likely to be converted into cash or probably consumed or exhausted within a financial year are termed as current assets.
Current Liabilities
The debts or liabilities that a company is expected to make good within a year are classified as current liabilities.
Total Equity
Total equity refers to the owned capital of an organization held by the shareholders or private owners. It is the difference between the total assets and total liabilities of a company.
Inventory
Inventory refers to the value of goods (raw materials, semi-finished and finished products) held by an organization.
Hence, it is crucial to understand all these terms before delving deeper into the topics of accounting. You must have a holistic understanding of all these to strengthen your foundation so that you can navigate through the advanced topics more conveniently.
What is the Basic Accounting Equation?
The basic accounting equation is Assets = Equity + Liability.
It is also known as the balance sheet equation. The double-entry bookkeeping system is founded on this very equation, as it represents that the total credit balance equates to a total debt balance.
What is the Comprehensive Accounting Equation?
A comprehensive formula for the basic accounting equation is its expanded form. Commerce students have to note that multiple different factors are included in a firm, proprietorship, or company.
Hence, while calculations are carried out, there might be a slight change in the parameters that are considered. For instance,
In the case of a corporation, Assets = Liabilities + Paid-in Capital + Revenues – Expenses – Dividends – Treasury Stock
Similarly, in the case of a sole proprietorship is: Assets = Liabilities + Owner's Capital + Revenues – Expenses – Owner's Draws
Hence, it is evident that certain parameters differ based on the entity for which the valuation of assets is being done.
To know more about accounting activities and their formulas in calculating those, look into our online learning programmes for a clear understanding. We provide high-quality study materials prepared by subject professionals to guide you on the right path towards effective exam preparation. So, get your notes now and jumpstart your exam preparation.
FAQs on Accounting Formulas: A Comprehensive List
1. What is the basic accounting equation?
The basic accounting equation is Assets = Liabilities + Equity. It forms the foundation of the double-entry accounting system and represents the structure of a balance sheet. This formula shows that a company's total assets are financed either by borrowing from others (liabilities) or through funds from its owners (equity).
2. How is the expanded accounting equation different for a sole proprietorship and a corporation?
The expanded accounting equation provides more detail by breaking down the 'Equity' component. The core principle is the same, but the terms differ based on the business structure:
- For a Corporation: Assets = Liabilities + Paid-in Capital + Revenues – Expenses – Dividends – Treasury Stock.
- For a Sole Proprietorship: Assets = Liabilities + Owner's Capital + Revenues – Expenses – Owner's Draws.
3. What are the key formulas used to analyse a company's profitability?
Key profitability formulas measure a company's ability to generate earnings from its operations. The most essential ones for analysis include:
- Gross Profit Margin: (Gross Profit / Sales) × 100. This shows the profit made on the cost of goods alone.
- Net Profit Margin: (Net Income / Sales) × 100. This reveals the final profit after all expenses, including taxes and interest, are deducted.
- Return on Equity (ROE): (Net Income / Average Shareholder’s Equity). This measures how efficiently the company uses shareholder funds to generate profit.
4. Which formulas are crucial for understanding a company's liquidity?
Liquidity formulas assess a company's ability to meet its short-term debt obligations. Two primary formulas are:
- Current Ratio: Current Assets / Current Liabilities. A ratio greater than 1 generally suggests a company can cover its short-term debts.
- Quick Ratio (or Acid-Test Ratio): (Current Assets - Inventory) / Current Liabilities. This is a stricter measure because it excludes inventory, which may not be easily converted to cash.
5. What is the formula for the Cost of Goods Sold (COGS) and what does it represent?
The formula for the Cost of Goods Sold is: COGS = Opening Inventory + Purchases – Closing Inventory. COGS represents the direct costs attributable to the production of the goods sold by a company. This includes the cost of raw materials and direct labour but excludes indirect costs like marketing or administrative salaries.
6. Why is the basic accounting equation (Assets = Liabilities + Equity) always in balance?
The accounting equation always balances because it is the core of the double-entry bookkeeping system, where every transaction has an equal and opposite effect on at least two different accounts. For example, if a company buys equipment on credit, its assets (equipment) increase, and its liabilities (accounts payable) increase by the same amount, keeping the equation perfectly balanced.
7. How does the Current Ratio differ from the Quick Ratio, and when would you use one over the other?
The main difference is the treatment of inventory. The Current Ratio includes all current assets, while the Quick Ratio excludes inventory. You would use the Quick Ratio for a more conservative and immediate assessment of a company's ability to pay its current debts, especially in industries where inventory is slow-moving. The Current Ratio gives a more general overview of short-term financial health.
8. What is the practical difference between Gross Profit and Net Income, and why must a business track both?
The practical difference is the scope of expenses deducted from revenue. Gross Profit (Sales - COGS) measures core production and pricing efficiency. Net Income is the final 'bottom-line' profit after *all* expenses (operating, interest, taxes) are deducted. A business must track both because a healthy Gross Profit but low Net Income points directly to high operating or non-operating expenses that need control, whereas a low Gross Profit points to issues with production cost or pricing strategy.
9. How can a high Inventory Turnover Ratio be a bad sign for a business?
While a high Inventory Turnover Ratio (COGS / Average Inventory) usually indicates strong sales, it can be a negative sign if it is too high. It may suggest that the company is carrying insufficient inventory, leading to frequent stock-outs and lost sales. This can damage customer relationships and reputation, indicating that an overly aggressive inventory reduction strategy is harming the business's ability to meet demand.
