How to Read a Balance Sheet
The purpose of a balance sheet is to illustrate a company’s net worth. Net worth on a balance sheet is usually called: Equity. In its simplest form, a balance sheet will simply list a company’s assets (items of value that the company owns) and the company’s liabilities (amounts owed to others, usually for the items owned). Then from these two lists (Assets and Liabilities) it will calculate the owner’s equity. Owner’s Equity is simply calculated by subtracting the sum total of the liabilities from the sum total of the assets.
Formula: Assets – Liabilities = Equity
| Assets (What We Own) | ||
|---|---|---|
| Cash in Banks | $10,000 | |
| Equipment | $50,000 | |
| Liabilities (What We Owe – usually owed against what we own) | ||
| Equipment Loan | ($40,000) | |
| Equity | ||
| Net Worth | ($20,000) | |
| $60,000 | $60,000 |
The company in this illustration has $60,000 worth of property and cash (Assets). In addition, it has $40,000 in loans (Liabilities) owed on its equipment. As a result, using the formula Assets – Liabilities = Equity, this company shows to have a net worth (or Equity) of $20,000.
So, in theory if we sold off all of the Assets (assuming they are valued correctly), and used the proceeds of the sale to pay off our loan, we would have $20,000 remaining.
Remember, a balance sheet shows the business owner three things:
- What he owns
- What he owes to others
- What he is worth
As small business owners, the goal is to grow net worth!
How to Read an Income Statement
Business owner and investors like to look at the income statement (a.k.a. “earnings statement” or “statement of operations”) because it shows a company’s “bottom line”: its earnings, or profit. Simply stated it lists the company’s (1) revenue, (2) expenses, and (3) calculates the profit or loss. To properly manage a business, an accurate (and timely) income statement is a necessity.
| Revenue | $100,000 | |
|---|---|---|
| Cost of Sales | $80,000 | (80% Cost of Goods Sold) |
| Gross Profit | $20,000 | (20% Gross Profit) |
| Operating Expenses | $15,000 | (15% Overhead Burden) |
| Net Profit (or profits from operation) | $5,000 | (5% net profit margin) |
How to Calculate Markup Percentage
When using a markup percentage, the unit cost multiplied by the markup percentage added to the original unit cost will calculate the sales price.
For example, if a product costs $100, the selling price with a 25% markup would be $125:
- Gross Profit Margin (Sales Price – Unit Cost) = $125 – $100 = $25.
- Markup Percentage = Gross Profit Margin ÷ Unit Cost = $25 ÷ $100 = 25%.
- Sales Price = Cost x Markup Percentage + Cost = $100 X 25% + $100 = $125.
How to Calculate Gross Margin Percentage
Gross margin defined is Gross Profit ÷ Sales Price. In this example, the gross margin is $25. This results in a 20% gross margin percentage:
Gross Margin Percentage = Gross Profit ÷ Sales Price = $25 ÷ $125 = 20%.
How to Determine the Selling Price to Achieve a Desired Gross Margin
By dividing the cost of the product (or service) by the inverse of the gross margin percentage, you will arrive at the selling price needed to achieve the desired gross margin percentage.
For example, if a 25% gross margin percentage is desired and the unit cost is $100, the selling price would be $133.33 and the markup rate would be 33.3%:
Sales Price = Unit Cost ÷ (1 – Gross Margin Percentage) = $100 ÷ (1 – .25) = $133.33
Markup Percentage = (Sales Price – Unit Cost) ÷ Unit Cost = ($133.33 – $100) ÷ $100 = 33.3%
Margin vs. Markup Chart
- 15.0% Markup = 13.0% Gross Profit
- 20.0% Markup = 16.7% Gross Profit
- 25.0% Markup = 20.0% Gross Profit
- 30.0% Markup = 23.0% Gross Profit
- 33.3% Markup = 25.0% Gross Profit
- 40.0% Markup = 28.6% Gross Profit
- 43.0% Markup = 30.0% Gross Profit
- 50.0% Markup = 33.0% Gross Profit
- 75.0% Markup = 42.9% Gross Profit
- 100% Markup = 50.0% Gross Profit
Bruce H. SmithCEOSafety Vision, LP