The key to any successful business is strong and accurate finances. As a small business owner, having at least a basic understanding of accounting terms and principles will help you identify areas of your business where you can improve or grow and set you on the pathway to success.
A dedicated accounting professional or accounting software is essential for growing a business, but many small business owners choose to manage the finances themselves in the early stages of a new business. If you plan on handling your business accounting yourself, even if just for the immediate future, learning the jargon will make the process much less daunting.
Accounting 101: Financial Statements
Before we can dig into accounting terms, it’s important to understand the purpose and value of financial statements, which are records of your company’s financial performance and activities. Before you start managing your business finances, there are two financial statements you need to understand: a balance sheet and a profit and loss statement (also known as a P&L or an income statement).
A balance sheet presents all of your company’s assets, liabilities, and equity as of the date the document is prepared. The balance sheet equation, also known as the accounting equation, is Assets = Equity + Liabilities.
Keeping this equation in balance is the underlying principle of all accounting transactions. Typically, assets are listed on the left side of a balance sheet and equities and liabilities on the right.
Profit and Loss Statement
A profit and loss statement (P&L), or an income statement, shows your company’s financial performance based on revenues, expenses, and the profits or losses of a specific time period, often broken down into quarters. This is considered one of the most important accounting documents because it outlines your company’s financial health.
Typically, revenue is listed at the top of the document, and all expenses are subtracted from it. The calculation results in either profits or losses (also called net income). Your net income is your company’s total earnings.
Important Accounting Terms to Know
Now it’s time to dive into other terms that will help you better understand financial statements and other important accounting documents and processes. We’ve compiled a handy list of basic accounting terms below to help get you started!
Accounts payable is defined as the money your business owes creditors or suppliers and is considered a liability. This liability is recorded on your company’s balance sheet.
Accounts receivable is the amount of money your customers or clients owe you for goods or services you’ve provided but that they have not yet paid. Accounts receivables are legally enforceable claims and appear as assets on your balance sheet.
This is the standard accounting method for most companies. If you’re using the accrual accounting method for your business, you must record expenses and revenue as you accrue them, regardless of when cash for the good or service is actually exchanged.
Very small businesses or small service companies with no inventory can use cash-based accounting, where income and expenses are recorded right when cash is exchanged. If your small business has inventory or you sell your goods/services on credit, you must use accrual accounting.
An asset is a resource, such as equipment or inventory, that will provide a future benefit to your company. If you’ll recall, assets are part of the accounting equation, where assets equal the sum of your liabilities and equity. As a small business owner, it’s important to understand two types of assets: current and fixed.
A current asset is an economic resource that is expected to convert into cash in one year. Things like cash, inventory, and accounts receivable are all examples of current assets.
A fixed asset is a long-term economic resource, such as equipment or real estate properties that are not as easily converted into cash.
Burn rate is a calculation of how much money your business spends over a given period.
To calculate your business’ burn rate, choose a time period—say a quarter. Next, find the difference between the cash you have at the end of the period to the cash you had at the beginning of the period. Divide that number by the number of months in the period, in this case, 3 months, and that’s your burn rate!
Starting balance – Ending balance = Difference
Difference / Number of Months = Burn Rate per Month
Capital is a financial asset or the value of a financial asset, such as funds, cash, and manufacturing equipment.
Cash flow describes the revenue generated through business activities. Ideally, you want to have a positive cash flow. To calculate your cash flow for the month, subtract your cash balance at the end of the month from your cash balance at the beginning of the month.
There are two types of costs: fixed and variable. A fixed cost is a cost that does not change regardless of how many sales your business generates. This includes things like salaries or rent.
A variable cost is a cost that does change depending on the volume of your sales. For instance, when the demand for your product increases, the cost of materials to meet that demand will increase as well.
Cost of Goods Sold
Cost of Goods Sold, or COGS, are the expenses required to create your business product or service. Things like the cost of your product’s materials or the labor required to provide your service are COGS.
Equity describes the portion of your company that is owned by you and your investors. Recall that Assets = Liabilities + Equity. If you subtract your assets from your liabilities, you’re left with your business’ equity.
A general ledger is a total record of all of your business’ financial transactions, both debit and credit included. This document is required to prepare all Financial Statements.
Inventory refers to all of the finished goods your business sells, and all the raw materials used to produce said goods. Inventory is classified as an asset in your balance sheet.
Liabilities are cash or goods your business owes somebody else, also known as financial debts. Liabilities are a part of the accounting equation on your balance sheet, and include things such as loans, mortgages, and accounts payable.
Profit is the money generated by your small business after accounting for all of your expenses. To calculate profit, subtract total expenses from total revenue.
Return on Investment
Return on Investment (ROI) is a measurement of the financial return on a particular investment relative to its cost. The ROI formula is:
(Current Value of Investment – Cost of Investment) / Cost of Investment) = ROI
Tackling Your Small Business’ Accounting and Bookkeeping
Understanding accounting terminology can feel overwhelming for anyone, but having a solid foundation is crucial for any small business owner looking to manage their business’ books themselves. Once your business has surpassed the point in which you have the capacity or knowledge to take on accounting tasks, consider outsourcing your accounting and bookkeeping services to a comprehensive online provider, such as ScaleFactor. Request a free demo to learn how ScaleFactor can best help your business reach its financial goals.