Accounting 101 – Critical Accounting Knowledge to Help You Run a More Efficient and Profitable Business
What is Accounting?
Accounting is the process of recording all of the financial transactions of a business. The process is a critical component of the business because it shows financial inconsistencies and redundancies which, when corrected, could lead to a better functioning business. Having complete and accurate accounting records can make the difference between business success and business failure.
Why does Accounting matter to you?
Understanding the financial health of your business is key! You have invested significantly in your business – your time, your money, your sanity, and a great deal is riding on your success. Without proper accounting, you can never have a true, real-time gauge of the financial health and value of your business. As the owner, it is your responsibility to manage your business’ assets and liabilities. You cannot do this without access to the proper accounting records and reports.
Be a better candidate for future financing! Unless you are independently wealthy and willing to personally fund any capital needs your business may have, the time will come when you’ll need to get some cash from someone else. This can happen for several reasons.
Your business may just grow like a weed, and you may need a line of credit to help fund that growth spurt. Or, you may experience an unexpected setback and need capital to keep things running smoothly until your cash improves.
Whatever the reason, if you have current and accurate accounting records, getting the money you need from a bank or potential investors, will be much easier to do.
Reach your goals faster! Whatever your goals may be – selling your business for a lump sum, providing a stream of income in your retirement years, or doing something else with it – proper accounting help gets you there faster.
Accounting provides you with the insight you need to make better decisions about your business finances. Better decisions directly impact the short- and long-term success of your business.
If you are guessing at your business’ strength by checking your bank balance and making financial decisions based on who is calling you for money, then you aren’t managing your business….your business is managing you!
If you don’t know how or when to adjust spending or cut expenses or a product/service, and you are just making guesses based on gut feelings….you should realize that accounting will help you understand the past and see in to your future. Running a business is hard enough – don’t make it harder.
Be more efficient in the long run! The longer you wait to implement proper accounting systems in your business, the more it will cost to implement one in the future. Starting from day one will prevent costly mistakes that will eventually need to be corrected.
Manually culling through hundreds or even thousands of invoices or receipts months or years after the fact, will cost exponentially more than implementing a simple accounting system at the outset of your business.
Like any technical discipline, accounting can be demystified by learning a few key words, phrases, and concepts. We can’t teach you what it takes accountants 4+ years to learn in school, but here is a basic primer for you to start with.
Accounting: In every business, money comes in and money goes out. Accounting is nothing more than tracking the when, who and how much of money flowing through your business.
Assets & Liabilities: Both in the accounting and financial worlds, assets and liabilities are reported on your Balance Sheet. An asset is anything your business owns. Examples are cash, accounts receivable, inventory, office supplies, equipment, pretty much any tangible (or intangible) item your business owns.
A liability is something you owe to someone else. This would be your accounts payable, equipment loans, credit card, tax liabilities. Unless liabilities exist for a specific or strategic purpose (let’s say, to buy a building), you want to keep them to a minimum.
The goal is to have your assets grow and your liabilities shrink.
Debits & Credits: Debits and credits are accounting specific terms. For every amount posted as a credit, there must be an equal debit. Debits increase the balances in assets and expense accounts. While credits increase the balances in liabilities, equity and income accounts.
Double-Entry Accounting: This simply refers to showing both sides of any transaction. For example:
You take $75 out of checking account (an asset account) to buy a case of copy paper (office expense account). To reduce the balance in your checking account, you credit the account for $75. To increase the balance of your office expenses, you debit the account for $75. Your debit now equals your credit.
Pretty simple, right? Double-entry accounting helps keep track of your money by showing debits and credits based on money you’ve spent or earned.Every transaction must be recorded. Every. Transaction.
Income Statement: Also known as a Profit & Loss statement, or a P&L. This financial report displays your income and expenses for a specific time period. Sometimes monthly, and definitely at the end of the year.
The income statement is an important part of the business’s tax return and is used to help the business owner identify trends in their business that either make them more profitable or make them lose money.
Expense: This one is simple. An expense is anything reasonable and customary that your business pays and is generally deducted in the current period. When expenses exceed your income, you have a loss.
General Ledger: The G/L is the recording of all your debits and credits.
Balance Sheet: The Balance Sheet is a snapshot of your business’ financial position at any given point in time. The report shows the business’ assets, liabilities, and equity. This financial report shows how flush you are (or aren’t) with cash…and how burdened you may be with debt.
Fixed Costs: These are expenses your business incurs on a regular basis that do not fluctuate with sales. Rent, phone bill, and internet fees are good examples of fixed costs. Sometimes they are collectively referred to as “overhead” or “general administrative expenses”.
Variable Costs: These are the opposite of fixed cost and fluctuate based on increases and decreases in sales. An example of a variable cost can be shipping costs. Let’s say you ship your product to your customers. The more sales you have, the more product you ship, the higher your shipping costs will be.
Owner’s Equity: As the business owner, you pretty much own all the assets of the business. The equity is the difference between the assets and the liabilities. For example, if your assets total $100,000 but your business owes $35,000 in liabilities, Owner’s Equity would be $65,000. Equity becomes little more complicated when there is more than one owner, or the business is a corporation.
Cash or Accrual Accounting: These terms identify accounting methods. They represent two different ways of reporting financial transactions. The cash method is “real time”, which mean you report income when it is paid to you, and you report expenses when you pay the bill. On the other hand, accrual method records income and expenses when they are earned or incurred…regardless of when your customer pays you or you pay the bill. Here is an example:
ABC Company invoices customer $1,000 on January 1st – customer pays on February 3rd.
ABC Company receive phone bill of $250 for January – pays the bill on February 15th
January: No income or expense reported
February: Income of $1,000 and $250 expense reported
January: Income of $1,000 and $250 expense reported
February: No income or expense reported
Common Financial Reports
Reports, reports, and more reports! They are the key ingredient to business management. Small things happen in your business every day and combine to create a large impact on your business’ financial success. There is no way to know these things if you can’t see them – and the financial reports is where you will see them.
Account Statements: These are the monthly, quarterly or annual statements provided to you by a third party. These could be bank statements, credit card statements, and loan statements. Comparing these statements with your internal accounting (also known as reconciling) quickly reveals errors and potential fraud.
Income by Customer: Not all customers are created equal. Some pay on time, some late, and some, not at all. By reviewing your customers and seeing who is or isn’t paying timely, can help you create policies that ensure your customers pay on time. Not managing when or if your customers are paying you, is sure way to creating cash shortfalls, which could lead to business failure.
Expense by Vendor: For many small businesses, your vendors are an extended part of your team. This can include your accountant, marketing consultant, printer, and more. Reviewing the expenses by vendor can give you important information to help you negotiate discounts, delivery and payment terms. The review can also let you know if you should start looking for additional providers of important services or products.
Receivables: This report shows you who owes you money. Paying regular attention to this report will show you what customers are late with remitting payment and if you may need collections assistance. Regularly ignoring this report can quickly result in never getting paid for products or services you have provided.
Payables: This is sort of the opposite of Receivables. This report shows you who YOU owe money to. Remember, timely paying your bills impacts your business credit and influences the relationship you have with your vendors. Let’s say you have an urgent need for some supplies for a customer order. You reach out to your vendor to ask for a rush delivery…and they say no because you either have late bills you haven’t paid or are consistently late at paying. They are not likely to “jump” to help if they know they either won’t get paid or will get paid late.
Sales: Ok, sure. This does seem like an obvious one. But you would be surprised! This report tells you what products/services are selling, and which ones are not. It also will let you know who is buying your products and services. This is important information that helps you make decisions on ordering, staffing, financing, product needs, and possibly changing your product/service offerings.
Income Statement: Also known as Profit & Loss or P&L. This report summarizes all your business operations (income/expense) in one place. This report can be prepared on a weekly, monthly, quarterly, and annual basis. And it can be prepared on a cash or accrual basis. Many business owners don’t want to look at this report because they are worried they won’t like what they see. However, reviewing and understanding this statement is necessary in order to make informed decisions that increase the profitability and sustainability of your business.
Balance Sheet: The current profitability, creditworthiness, and saleability of your business are reflected on the Balance Sheet. While the Income Statement shows operating activity for a particular period of time, the Balance Sheet shows the accumulation of business activity as of particular date.
How to Measure Success
You have learned the terms and have an understanding of some of the most common financial statements. Now you need to pull these together and be able to see how your business is performing. Here are a few common indicators you can monitor that show you are on the right track.
Accurate & Organized Records: Operating your business with complete, accurate and organized accounting records allows you to track money coming in and going out (cashflow), and what is or isn’t left (profit or loss). This data helps you analyze all aspects of your business from the types of services/products you offer…to negotiating payment terms with vendors.
Cashflow: Cashflow is one of the easiest ways to measure the health of your business. If you have collected all your sales and paid all your bills, and you have money left over – then you have positive cashflow. That’s a good thing! It doesn’t directly correlate to your profit, but it is a good indicator that the business is financially healthy. A negative cashflow (not enough money to pay the bills and reliance on debt to pay bill) is a warning sign that some things about your business need to be addressed or your business may be failing.
Can You Do This Yourself or Do You Need an Accountant?
This is a tricky question. The answer is as individual as every business. Here are things to consider when trying to answer this question:
How comfortable are you with managing finances in general? Some people just don’t have the knack for it. And that is okay.
How much time do you have on a daily, weekly, monthly basis to handle the financial responsibilities of your business? These are tasks that need to be done on a regular basis, not at the end of the year when you want to prepare your tax return.
Is it possible, and more efficient, to bring in an expert or do you just need help to get set up? Sometimes just getting the foundation of your books set up by an expert, and having them set you in the right direction, may be enough. An expert can be there to help as little or as much as you want.
Could you use your time elsewhere in your business and make more progress towards higher profitability? Sometimes it is more financially beneficial to hire an expert so you can do what you are an expert at…and that is providing the products/services your business offers.
As the business owner, the final decision on what is best for your business, is yours to make. Here are six areas where having an accounting expert in your corner helps.
Getting Your Business Started
What entity is right for your business?
How much should you charge for your product/service?
How do you handle employees and/or subcontractors?
2. Fiscal or Calendar Year
Many businesses run on a calendar year, but not all.
If a fiscal year is best for your company, what should it be?
3. Ongoing Management and Insights
You are busy juggling many things – having an accounting professional to call to ask for guidance, can be a life saver!
Financial performance insights from an unbiased, knowledgeable third party helps mitigate the risk of business failure.
Filing business returns is complicated. Do you know what forms are required? An accounting professional stays current on tax law and knows what laws that are out there can help reduce your taxes.
Sales tax and payroll tax can be overwhelming to business owners. If not prepared properly and filed timely, the penalties can easily put a small business out of business.
Thank you for reading this guide. We hope it has been educational and helpful. We believe understanding what accounting really is and why it is important, will give you an edge in making your business a success.