## 10 useful accounting formulas

The following are some of the most frequently used accounting formulas. This list is not comprehensive, but it should cover the items you’ll use most often as you practice solving various accounting problems.

## Balance sheet formula

Assets – liabilities = equity (or assets = liabilities + equity)

This basic formula must stay in balance to generate an accurate balance sheet. This means that all accounting transactions must keep the formula in balance. If not, the accountant has made an error.

## Retained earnings formula

Beginning balance + net income – net losses – dividends = ending balance

## Income statement formula

Revenue (sales) – expenses = profit (or net income)

Keep in mind that revenue and sales may be used interchangeably. Profit and net income may also be used interchangeably. The income statement is also referred to as a *profit and loss statement.*

## Gross margin

Sales – cost of sales

Gross margin is not a company’s net income or profit. Other expenses, such as selling, general, and administrative (SG and A) expenses, are subtracted to arrive at net income.

## Operating income (earnings)

Gross profit – selling, general, and administrative (SG and A) expenses

## Statement of cash flows formula

Beginning cash balance + cash flow sources (uses) from operations + cash flow sources (uses) from financing + cash flow sources (uses) from investing = ending cash balance

This formula adds cash sources and subtracts cash uses.

## Inventory formula

Beginning inventory + purchases – cost of sales = ending inventory (or beginning inventory + purchases – ending inventory = cost of sales)

## Net sales formula

Gross sales – sales discounts – sales returns and allowances

## Book value of fixed (depreciable) assets

Original cost – accumulated depreciation

## Straight line depreciation

(Original cost – salvage value) / number of years in useful life

*Salvage **value *is the dollar amount that the owner can receive for selling the asset at the end of its useful life.

## Financial statement formulas

After you create financial statements, you need some tools to analyze a company’s results. Following are the most frequently used formulas to analyze financial statements. Get familiar with them so that you can analyze statements with confidence.

## Components of work-in-process

Direct materials + direct labor + factory overhead applied

Work-in-process (WIP) represents cost incurred in production for partially completed goods. WIP is a subaccount within inventory. When goods are completed, they are moved to finished goods (another inventory account).

## Current ratio

Current assets ÷ current liabilities

The current ratio illustrates how easily a company can cover its current bills.

## Quick ratio

(Current assets less inventory) ÷ current liabilities

The quick ratio excludes inventory from current assets. The rationale is that inventory is the current asset that will take the longest time to convert into cash. Other current assets, such as collecting accounts receivable, may be converted into cash more quickly.

## Asset turnover ratio

Revenue (or sales) ÷ assets

This ratio explains how much profit a company generates for every dollar of assets.

## Return on equity

Net income ÷ equity

This ratio explains how much profit a company generates for every dollar of equity.

## Debt to equity ratio

Debt ÷ equity

This ratio measures what percentage of a firm’s total capitalization is debt. Capitalization refers to all funds raised by the company to operate the business.

## Contribution margin

Sales less variable costs

Contribution margin represents the amount that will be used to cover fixed costs. Any dollars remaining after paying fixed costs is considered profit.

## Return on capital

Operating profit ÷ capital

Capital is similar to equity. It represents funds raised to operate a business. Operating profit refers to profit generated from normal business activity.

## Break-even formula

Sales – variable costs – fixed costs = $0 profit

The break-even formula calculates the level of sales that will generate a profit of $0.

## Formula to assign overhead costs

Total overhead costs incurred ÷ activity level

Overhead costs, such as a factory’s utility costs, can’t be directly traced to a product. Instead, overhead costs are allocated based on an activity level. The activity level chosen should impact the amount of overhead costs incurred. For example, the number of machine hours used drives machinery repair costs. Machine hours should be the activity level for machine repair costs.

## More financial analysis formulas

After you create financial statements, you need some tools to analyze the company’s results. Following are some additional formulas accountants use to analyze financial statements. Become familiar with these formulas, and use them as you practice various accounting problems.

## Burden rate

Fixed manufacturing costs ÷ units produced

Fixed costs can’t be directly traced to a unit produced. For example, a $50,000 monthly factory lease must be paid, regardless of the number of units produced in a given month. To assign fixed cost to each unit of product, companies used the burden rate.

## Cost of idle capacity

Percentage of available capacity unused × fixed manufacturing overhead costs

*Idle capacity* refers to unused capacity. Assume you could produce 20% more baseball gloves this month, using your existing factory costs (materials, labor, and overhead). Say that the factory pays a foreman $50,000 in salary and benefits to supervise production. The cost of idle capacity is 20% multiplied by $50,000, or $10,000. The firm is paying an extra $10,000 for production capacity it’s not using.

## Calculating loan interest

Interest rate for period × principal amount of loan

Interest can be compounded (computed) annually, monthly, or even daily. Pay attention to the stated annual interest rate on the loan and how often interest is compounded. If a 12% loan is compounded monthly, the monthly interest rate is 12% ÷ 12 months, or 1%.

## Effective interest rate

Interest paid ÷ principal amount owed

Because of the effects of compounding, the actual interest paid on a loan may be different from the stated interest rate on the note multiplied by the principal.

## Present value and future value factors

Present value factor less than 1; future value factor more than 1

A present value factor discounts a cash flow to its present value. To calculate the present value, you multiply the factor times the cash flow amount. A present value factor will be less than 1. The future value of a cash flow adjusts the cash flow to its future value, given an interest rate. A future value factor will always be more than 1.

## Return on investment (ROI)

Profit (net income) from investment ÷ cost of investment

A more complex version of the formula is operating income divided by operating assets. Operating assets represent an investment in a project or business. The purpose of this formula is to determine the profitability of a given project.

## Return on investment (DuPont model)

Profit margin × asset turnover

This is a more complex formula that’s used for ROI. Profit margin is operating profit divided by sales. Asset turnover is calculated as sales divided by average assets. Average assets refers to assets at beginning of period + assets balance at end of period ÷ 2.

## Return of investment to shareholders

Retained earnings balance – payments to shareholders

A *dividend* is a payment of retained earnings to shareholders (investors). If a company makes payments to shareholders that are greater than the balance of retained earnings, those payments are a return of the investors’ original investment.

## Rule of 72

72 ÷ rate of return on investment

The *rule of 72* states how many years it will take for a sum of money to double, given a rate of return that is compounded each year. If, for example, the rate of return is 8%, a sum of money will double in 72÷8, or 9 years.

## Weighted average cost of capital (WACC)

Annual cost to obtain financing ÷ capital balance

Companies can raise funds by issuing debt or equity. Outstanding debt requires annual interest payments. Shareholders who purchase equity may also insist on required annual dividend payments. Interest payments on debt and dividend payments to shareholders are both considered financing costs. The annual cost of financing divided by the funds raised to operate the business (capital) is WACC.