Here’s a secret they don’t tell you when you start a business: to be successful over the long term you should get familiar with the numbers in your business. Most entrepreneurs don’t have an accounting background, so this part of owning and running a business can involve a steep learning curve.
Before you tune out, understand that learning the basics of small business accounting isn’t just about filing tax returns. Reviewing and understanding financial reports can make you more confident about making business decisions, including when to hire and expand or when to seek small business financing.
Here are 18 basic accounting terms you’ll want to know, with simple explanations to help you understand why you’ll want to pay attention to them.
1. Expenses: A cost incurred in order to do business.
Why it’s important: Both variable expenses and fixed expenses can impact your profitability. Expenses can be broken down even further; variable expenses, for example, may be categorized under operating costs or costs of goods sold (COGS). Evaluating your business expenses on a regular basis may help you save money and increase net profits (profits after expenses are paid).
2. Revenue: Income from business activities.
Why it’s important: Sales are how small businesses make money, and they increase gross profits. If you’re not bringing in enough revenue, your business will not be profitable or sustainable.
What you may not know is that many small business lenders review revenues when making small business loans. They may require copies of business bank account statements to verify that your business makes their minimum required amount of money (usually averaged over the last 3-6 months) and to see whether total revenues are increasing or decreasing.
3. Assets: Anything of value a business owns.
Why it’s important. Sales bring in money but company assets can help build value over time. You may also be able to liquidate assets for short-term cash needs. These can include physical assets such as real estate, equipment, or the amount of cash in the bank, and can also include less tangible items such as intellectual property (trademarks or patents) or goodwill. Good business credit can be an asset, too.
It’s also important to protect assets with various strategies, including creating a formal business entity (LLC, S Corp or C Corp, for example) and by making sure you have adequate business insurance.
4. Liabilities: A company’s debts; what it owes.
Why it’s important: Your business must make enough money to pay its debts on time, or it will face consequences such as collections, lawsuits or even bad debt. Debts may include money owed on small business loans, as well as accounts payable. Simply looking at the money you bring in without paying attention to liabilities can be a costly mistake.
5. Cash flow: The money coming into and leaving a company.
Why it’s important: Cash flow is one of the most important indicators of small business financial health. A business can be making sales but if invoices owed to the company are received slowly, for example, it may make it difficult for the business to pay employees and other expenses on time. Cash flow problems are one of the top reasons small businesses fail.
6. Cash flow statement: A financial statement that compares cash received to cash paid out.
Why it’s important: Cash flow statements compare cash received from sales as well as interest or investment income, to cash paid out for any number of expenses, including payroll, taxes, inventory etc. This financial report can help you understand whether your business can meet its expenses from current cash flow, or whether it needs to get additional funds from small business loans or investors. If you’re not familiar with your businesses’ cash flow statements, your accountant can help.
7. Balance sheet: A financial statement that shows total assets, total liabilities, and total shareholder equity at a specific point in time.
Why it’s important: The balance sheet is also important for understanding the current financial position of your business. It gives you a snapshot of your business finances and can help you understand your business financial performance. Your accountant or your accounting software can help you create one, or you can use a free balance sheet template.
8. Profit and Loss Statement: A financial statement that shows net income by looking at revenues and expenses over a specific period of time.
Why it’s important: Did your business make or lose money this quarter/year (or any other period)? Your profit and loss statement (also known as an income statement) can tell you that. Startups can use pro forma P&Ls to create projections until they start making money.
9. Accounts Receivable: Money owed to the company.
Why it’s important: There’s another fact of life many small business owners learn the hard way. You don’t earn money until your customer or client pays you. B2B companies (those that sell to other businesses), or B2C companies that do custom work (think construction) may find some customers pay slowly. And from time to time they don’t pay at all.
An accounts receivable aging report (a/r report) can help you see where those accounts stand, and how long your customers take to pay. It can also help you secure accounts receivable financing when you need to improve cash flow.
10. Accounts Payable: Money your company owes to other companies.
Why it’s important: Your business wants to pay its bills on time in order to maintain a strong business credit rating and to maintain good vendor relationships. If your business experiences cash flow fluctuations, a line of credit or even a small business credit card can provide the working capital you need to avoid falling behind on bills.
11. Equity: Equity refers to the value of a small business (assets minus liabilities).
Why it’s important: Building a business with strong equity will provide you with greater options if you choose to sell it or bring on investors through equity financing. Without equity, you may find yourself with more of a job than a business.
12. Depreciation: A calculation that figures out the worth of an asset over a period of time.
Why it’s important: Depreciation can help you understand when equipment may need to be replaced. It is also a term used to describe valuable tax deductions. As the IRS points out, depreciation can allow small business owners to recover the cost or other basis of certain property over the time they use the property.
13. Break even point: Refers to the point at which revenues equal expenses.
Why it’s important: Whether your business is a startup, or an established business introducing a new product, break even analysis helps you understand when you’ll move from losing money to making money. This is a key calculation for business planning purposes.
14. Burn rate: How much cash a business is spending before revenues generate positive cash flow.
Why it’s important: This term is used in association with startups that have received venture capital or other early state investment funding. The company relies on that investment capital until it is making enough money to pay expenses from cash flow. A business should eventually make money to pay its expenses from revenues, and generate profits. Otherwise it will constantly be seeking additional investment capital or financing.
15. Credit: Money the company has borrowed or a credit entry in an accounting ledger.
Why it’s important: Most of us are familiar with credit as a term to describe money borrowed. In accounting it’s a little different. A credit is an accounting entry that either increases a liability or equity account, or decreases an asset or expense account. If you work with a bookkeeper they will know how to enter this, and most accounting software makes it fairly simple as well.
16. Accruals: Recording of money coming in or out before invoicing or before payment is made.
Why it’s important: Businesses generally operate under one of two accounting methods: accrual accounting or cash basis accounting. With accrual accounting you revenues and expenses are recorded before they are paid.
17. Fiscal year: One year period of time for accounting purposes.
Why it’s important: Many businesses’ use a calendar year for accounting purposes, but not all do. For those that don’t the fiscal year will be used to create financial statements. You choose your accounting period when you start your business, so it’s wise to consult an accounting professional, such as a CPA, to help you make the right choice for your business.
18. Dividends: Income paid to shareholders of corporations each share of stock held.
Why it’s important: Dividends can be a way to reward shareholders who invest in a business either financially or in other ways. Note that LLCs do not pay dividends to LLC Members, but they can pay distributions.