6 Essential Accounting Terms for Small Businesses
Small business owners are advised to hire an accountant as it is considered best practice. However, it is important to note that delegating financial analysis and reporting does not mean complete detachment from the process on a monthly or quarterly basis. Instead, business owners should work closely with their accountants throughout the year to gain a better understanding of their financial position and make informed decisions for future growth. To facilitate more informed and insightful discussions with their accountants this quarter, small business owners can start by familiarizing themselves with six essential accounting terms.
1. Cash Flow
Cash flow is a critical metric for any business. It measures the amount of cash that is flowing in and out of the business over a given period. Cash flow is not the same as profits, as it takes into account all cash transactions, including investments, loan repayments, and other expenses.
If your business has more cash flowing in than out, you are considered to be cash flow positive. This is a positive sign for your business as it indicates that you have more money to invest in growth opportunities, pay off debts, and cover unforeseen expenses. Being cash flow positive also means that you are in a better position to weather any economic downturns or other financial challenges.
On the other hand, if your business has more cash flowing out than in, you are considered to be cash flow negative. This is a warning sign for your business as it indicates that you may be struggling to meet your financial obligations, such as paying suppliers, creditors, or employees. Being cash flow negative can also limit your ability to invest in growth opportunities and can make it more difficult to obtain financing from lenders.
To manage your cash flow effectively, you need to keep a close eye on your cash flow statement. This statement tracks all cash inflows and outflows, including sales, purchases, payments, and receipts. Your accountant will generate a cash flow statement each quarter to help you monitor your cash flow performance and identify any potential issues or opportunities.
2. Profit and Loss Statement
The profit and loss statement provides an overview of the financial health of your business, allowing you to make informed decisions that can help you achieve your financial goals. It’s important to review your P&L statement regularly to track your progress and identify areas where you can improve. A detailed analysis of the statement can help you identify trends in your revenue and expenses, giving you insight into how your business is performing and where you need to focus your efforts.
The revenue section of the P&L statement includes all money that your business has earned during the period. This includes sales, services, and any other sources of income. The gains section includes any one-time or non-operating income, such as gains from the sale of assets or investments.
On the other hand, the expenses section includes all the costs involved in running your business, such as rent, utilities, salaries, and materials. The losses section includes any one-time or non-recurring expenses, such as losses from the sale of assets or investments.
The bottom line of the P&L statement represents your net income (or net loss) for the period. If your expenses are greater than your revenues, your business is operating at a loss. Conversely, if your revenues are greater than your expenses, your business is profitable. Knowing your net income is critical for making informed decisions about how to allocate resources and plan for the future.
3. Gross vs Net Profit
Gross profit is an important financial metric that helps businesses calculate the profitability of their products or services. It is calculated by subtracting the cost of goods sold (COGS) from the total revenue generated from sales. Essentially, gross profit measures the amount of money a business earns from selling its products or services after taking into account the cost of producing or acquiring them.
However, gross profit alone does not give a complete picture of a business’s financial health. This is where net profit comes in. Net profit takes into account all operating expenses, including COGS, taxes, interest paid on debt, and any other expenses incurred in running the business. It represents the actual dollar amount of profit that a business earns after all expenses are deducted from revenue.
Calculating net profit is crucial for businesses, as it helps them determine their true profitability. By subtracting all expenses from revenue, businesses can get a clear idea of how much money they are actually making from their operations. This information can be used to make important decisions about pricing, cost-cutting measures, and investment strategies.
In addition, both gross and net profit are important metrics for benchmarking business performance against industry standards and competitors. By comparing these ratios with those of other businesses in the same industry, businesses can identify areas where they need to improve and make changes to increase profitability.
4. Balance Sheet
The balance sheet is a crucial financial statement that helps business owners and investors to understand the financial health of the company. It provides a clear picture of the company’s financial position by listing all the assets, liabilities, and shareholder equity. The assets section of the balance sheet includes all the tangible and intangible items that the company owns, such as cash, inventory, accounts receivable, and equipment. These assets are listed in order of their liquidity, with the most liquid assets, such as cash and accounts receivable, listed first.
On the other hand, liabilities are the obligations that the company owes to others, such as accounts payable, income tax, and employee salaries. These are also listed in order of their due date, with the liabilities that are due soonest listed first. The shareholder equity section of the balance sheet shows the amount of money that the shareholders have invested in the company. It includes the initial investment, as well as any additional investments made over time.
The balance sheet is a powerful tool for analyzing a company’s financial position, as it shows the net worth of the company at a particular point in time. By comparing the current balance sheet with previous periods, investors and business owners can see how the company’s financial position has changed over time. They can also use the balance sheet to identify areas where the company may be overextended or where it has excess cash that could be used to invest in growth opportunities.
5. Accounts Receivable & Accounts Payable
Accounts receivable and accounts payable are two essential financial concepts for any business. Accounts receivable refers to the money that a business is owed by its customers for goods or services provided. This includes both short-term and long-term receivables. Short-term receivables are typically due within a year, while long-term receivables may take several years to collect.
Accounts receivable are considered an asset on a business’s balance sheet because they represent money that is expected to be received in the future. This makes them an important factor in a business’s financial health, as they can be used to secure loans or other forms of financing.
On the other hand, accounts payable refers to the money that a business owes to its suppliers and any bills that have yet to be paid. This includes short-term liabilities such as rent, utilities, and salaries, as well as long-term liabilities such as loans and mortgages. Accounts payable are listed as a liability on a business’s balance sheet because they represent money that is owed to others.
Managing accounts receivable and accounts payable is crucial for maintaining a healthy cash flow and ensuring that a business can meet its financial obligations. This includes implementing effective billing and payment systems, monitoring payment terms, and negotiating favorable terms with suppliers. By keeping a close eye on these two financial metrics, businesses can better manage their finances and improve their overall financial performance.
6. Bad Debt Expenses
Bad debt is a term used in accounting to describe an amount owed by a customer that is unlikely to be paid. It is a common problem for businesses of all sizes, and can have a significant impact on their financial health. When a customer fails to pay their bill, it creates a cash flow problem for the business, and in some cases, can lead to insolvency.
There are several reasons why bad debt may occur. In some cases, customers may be unable to pay their bills due to financial difficulties. In other cases, they may refuse to pay for goods or services that they are not satisfied with. Regardless of the reason, bad debt can be a serious problem for businesses, and it is important to take steps to minimize its impact.
One way to minimize bad debt is to establish clear payment terms and policies. This can include offering discounts for early payment, charging interest on overdue accounts, and sending reminders to customers who are late in paying their bills. Another strategy is to perform credit checks on new customers before extending credit to them. This can help to identify customers who may have a history of late payments or defaulting on their debts.
In cases where bad debt cannot be collected, it may be necessary to write it off as a loss. This involves removing the outstanding amount from the accounts receivable balance on the balance sheet. While this can be a painful process for businesses, it is important to do so in order to maintain accurate financial statements and avoid overstating the value of accounts receivable.
Understanding the concept of bad debt is essential for anyone involved in accounting or financial management. By being aware of the risks associated with bad debt, and taking steps to minimize its impact, businesses can improve their financial health and make smarter decisions about their operations.