Running a business involves juggling multiple areas, sometimes in the same 20 minutes. You order inventory, figure out schedules for staff, get orders boxed up and shipped out, market your products and services, get the bills paid, send out invoices, and so much more. On top of that, you still have the bookkeeping to keep up with on a regular basis. Despite how overwhelming the financials of your business might appear to be, the truth is that you don’t need an accounting degree to successfully manage the financial health of your business. So what do you need to know?
What is accounting?
Accounting is known as the process of recording financial transactions for your small business or startup. It also includes:
- Creating financial statements
- Reporting to oversight agencies, regulators, or tax agencies
- Summarizing a company’s financial operations
No matter the size of your business, accounting is a necessary function for cost planning, decision making, and measuring its overall financial performance. While you might be able to use a bookkeeper for many basic accounting functions, a certified public accountant (CPA) is necessary for more advanced accounting tasks.
There are two types of accounting: managerial and cost. Managerial accounting assists leadership in making business decisions. Cost accounting assist you in deciding how much your products should cost. Using Generally Accepted Accounting Principles (GAAP), accountants provide an essential function for external compliance, strategic planning, operations management, and financing.
Why is accounting important for my business?
Savvy recordkeeping is key to monitoring your expenses and discover avenues of growth. By maintaining accurate records, you ensure that your tax liabilities are accurate, but also can provide backup should your business ever be audited. Plus, accounting helps you understand how your cash is being used, thus allowing you to implement a strong financial strategy. Your business hinges on clearly defined financial objectives that guide your decisions regarding expansion, changes in product lines, and more.
Bookkeepers work with three types of reports: balance sheets, cash flow, and income statements. Each report provides unique insights into your business and its financial health. To better understand your financial statements and what they tell you about your business, check out our Accounting 101 guide.
Accounting 101: Definitions
Before you dive into the accounting for your business, it’s important to understand the various terms you are likely to encounter. Knowing what they mean gives you the tools to analyze your financial reports and make critical decisions about the future of your business.
What is Accounts Payable?
Accounts payable is the method used to track money that you owe to any third party, which could include suppliers, vendors, or financial institutions. Common examples of accounts payable include:
- Purchases for goods or services
- Inventory
- Payroll
- Utilities
Typically, these payments are due immediately or have a short time for repayment to occur. For many businesses, items are purchased on account, demonstrating that cash was not involved in the transaction.
What is Accounts Receivable?
Accounts receivable is the current asset account tracking all the money owed by third parties to your business. These third parties can be banks, companies, or even people who borrowed funds from your business. A common example is funds owed to you for products or services sold that results in revenue. Sales done on account mean no cash was involved. Discounts might be offered to get payment sooner. These discounts can benefit both parties because the borrower gets a discount, while your business gets paid sooner.
What is Accrual Based Accounting?
Accrual based accounting is a bookkeeping method providing an accurate financial picture of your business operations. It recognizes business revenue and matching expenses when they are generated, not necessarily when funds exchange hands. For instance, if you receive an invoice for your electric bill, then accrual accounting would recognize that invoice as an expense, even if you have not yet paid the bill. You also pay taxes on all revenue earned, even if you have not yet received the cash payment.
It combines two key accounting principles:
- Matching principle – expenses should be recognized in the same period as the revenue they help to generate
- Revenue recognition principle – Revenue should be recognized when it is earned or realized, essentially when your business completes the action, such as initiating a service, thus entitling your company to revenue.
Accrual accounting records accruals on the balance, creating placeholders for cash events that will occur later, such as receiving payment on an invoice or paying a vendor when goods were bought on account. With this method, you also utilize accounts receivable and accounts payable to reflect earned revenue that hasn’t been paid for and liabilities reflecting what is owed but hasn’t been paid yet.
What is Cash Basis Accounting?
The alternative to accrual accounting is cash accounting. Typically used by small businesses whose owners pay taxes via personal tax returns, revenue and expenses are recorded based solely on cash flow. So you don’t record the bill until you actually pay it and don’t record revenue until you actually receive the payment. Taxes are paid only on the revenue you collected instead of on all earned revenue.
This method makes it easy to track cash flow since this method is very straightforward. The timing of when revenue and expenses are recorded can result in big swings in earnings from one financial period to the next.
What is the Balance Sheet?
Balance sheet is a financial statement reporting your assets, liabilities, and shareholder equity at a particular point of time. They provide the basis for computing rates of return and evaluating the capital structure of your business. It also gives you a snapshot of what your business owes and owns, along with what shareholders have invested. Combined with other financial statements, your balance sheet can assist in your financial analysis of your business’s health.
Keep in mind, your balance sheet is just an overview and can’t be used to determine trends over a longer period. Comparing balance sheets from several periods can assist you in identifying trends.
Benefits of Balance Sheet:
- Derive debt-to-equity ratio and the acid test ratio
- Provides context for assessing your financial health
- Adheres to accounting principles
What is the Profit and Loss Statement?
A profit and loss statement (P&L) is used to evaluate a company’s financial condition and prospects for future growth. Each entry provides insight into cash flow, showing where money comes from and how it is used. Your revenue is recorded, and then expenses are deducted to determine your net operating income. The P&L statement takes into account your outstanding debts, interest payments, and one-time deductions to arrive at your net profit.
Benefits of a P&L:
- Gives a comprehensive understanding of your company’s financial movements
- Detailed look at total revenue
- Detailed look at total debt or leverage
- Establishes current performance
- Helps to create forecasts for the future
- Compares performance from one company to another within industries
- Identifies unnecessary expenses and other areas of improvement
What is the Cash Flow Statement?
A cash flow statement summarizes the movement of cash and cash equivalents while measuring how well your business manages its cash position. It complements the balance sheet and income statement. With this statement, you can determine where money is coming from and how it is being spent. Creditors can use the cash flow statement to determine how much liquidity you have to fund operations and pay down any debts. It tells investors whether your company is financially solid before they invest.
It includes:
- Cash flow from operating activities
- Cash flow from investing activities
- Cash flow from financing activities
- Disclosure of non-cash activities
Cash flow is calculated by either the direct or indirect method. The direct method is best used for small businesses that use the cash basis accounting method since it uses actual cash inflows and outflows. The indirect method is calculated by adjusting net income by adding or subtracting differences from non-cash transactions. Your accountant can identify increases or decreases in assets and liabilities which impact the net income figure.
Benefits of a Cash Flow Statement:
- Valuable measure of strength, profitability, and long-term future outlook
- Demonstrates your company’s financial health
- Helps to see the relationship that accounts have on your net income
What is the Chart of Accounts?
A chart of accounts indexes all financial accounts, providing a digestible breakdown of all the financial transactions for a given period. They are broken down into subcategories. Each chart of accounts typically contains a name, brief description, and identification code.
By organizing their finances in this way, investors and shareholders have a clearer insight into your financial health by separating expenditures, assets, revenue, and liabilities, ensuring your financial statements are in compliance. Each account is typically shown in the order it appears on its financial statements. Balance sheet accounts are listed first, then income statement accounts. A chart of accounts can be tailored to reflect your operations but must still meet the guidelines set out by the Financial Accounting Standards Board and GAAP. A chart of accounts must remain the same from year to year in order for accurate comparisons to be made of your business and its financial health.
There are 5 account types:
- Assets
- Liabilities
- Revenue
- Expenses
- Equity
What is Credit and Debit?
Credits and debits are bookkeeping entries that essentially balance each other out. Every transaction must be exchanged for something else of the same value. A debit entry always adds a positive number, and a credit entry always adds a negative number (although you do not see positive and negative on any entries).
Credits and Debits:
- Are used in double-entry bookkeeping
- Record money flowing in and out of your business
- Utilized within your chart of accounts to record transactions
What is Depreciation?
Depreciation is used to allocate the cost of a tangible or physical asset over its useful life, representing how much of an asset’s value has been used. Companies are not required to account for assets entirely during the year they were purchased. If you don’t account for depreciation, it can negatively impact your profits. Depreciation can also help to reduce tax liabilities.
Using depreciation, you can spread out the cost of purchasing new equipment and thus match your expenses to related revenues during the same reporting period. This is a non-cash charge because there is no actual cash flow taking place when you use depreciation. Accumulated depreciation refers to the sum of all depreciation recorded on an asset up to a specific date. The carrying value of an asset is its historic cost minus the accumulated depreciation. Once all the depreciation has been taken, the carrying value of the asset is known as its salvage value.
Types of Depreciation:
- Straight line – Reports equal depreciation expense each year throughout the useful life of the asset.
- Declining Balance – Accelerates depreciation, causing a larger depreciation expense in the early carrying years, but it declines each year.
- Double Declining Balance – Takes the useful life of an asset, doubles it, then applies that rate to the depreciable base for the remainder of its expected life.
- Sum of the Years Digits – Allows for accelerated depreciation by creating a base sum that would be higher in the early years of the life of the asset.
What is Revenue, COGS, Expenses, Gross Profit, and Net Profit?
Revenue is the money your business brings in from its activities, which can be divided into operating and non-operating revenue. Companies use different calculations to determine their revenue, based on whether they are a service business, retail business, or manufacturer. Keep in mind, revenue is the gross proceeds collected by your business, but it only measures the income component of your operations.
COGS are the cost of good sold, which refers to the cost of producing an item or service. By knowing what your COGS are, you can price your products and services accordingly and also correctly calculate your profits. The COGS typically include direct and indirect expenses, such as the costs of materials, distribution costs, and sales force costs. The value of COGS sold will also depend on the inventory costing method used by your business.
Expenses are liabilities that must be paid by your company as part of doing business. These can include overhead costs, utilities, purchasing of inventory, paying staff, rent for your business space, loans, and more. These are deducted from your revenue to determine your profits.
Gross profit is what your company makes after deducting any costs associated with making or selling your products and services. It appears on your income statement and is calculated by subtracting COGS from your revenue. By determining your gross profit, you can assess how well your company is using its labor and supplies to produce your goods and services. A derivative of gross profit is gross margin. This margin indicates how much of your revenue can be used for your operating costs.
Net profit is the amount of profit your business has after all expenses are paid, which would include all working expenses that are not part of your gross profit calculation. Using the net profit margin, you can determine how much of each dollar of revenue translates into profit. Essentially, net profit and the net profit margin demonstrate how profitable your business is, which can impact opportunities for financing in the future.
What is a Fixed vs Variable Cost?
As part of understanding the financial health of your business, expenses should be divided into fixed and variable costs. Fixed costs typically do not change from month to month, making it easy to determine how much your business needs to cover these expenses. Variable expenses can be different month to month, since they increase and decrease based on your production and sales volumes. By analyzing these costs, you can budget and forecast to more effectively manage your cash flow.
In Summary
Accounting 101 is a basic guide to common accounting terms and methods, but it gives you the knowledge necessary to be able to understand your financial statements and what they indicate about the financial health of your business. Still, you might have questions unique to your business financial statements. By utilizing a high quality accounting service geared toward small businesses, you have a resource ready to answer your questions, while helping you to understand the options available for taking your business to the next level.
