Accounting Principles Your Small Business Should Know

Business owner with calculator

Finance and accounting are two topics that many small business owners dread and avoid until they have no choice but to confront. Despite the trepidation that comes along with spreadsheets and pages full of numbers, there’s a small set of key accounting principles to know as a business owner that can help you more effectively manage your operation.

Income Statement, Cash Flow Statement, and Balance Sheet

The three types of statements that all business owners need to know are the income statement, cash flow statement, and balance sheet. These three statements consolidate the entire universe of accounting information pertaining to your business.

Income Statement:  The income statement is the one that most are familiar with. It shows all sources of sales revenue and all operating expenses, and the difference between them (profit) over a period of time.

Cash Flow Statement:  The cash flow statement is most important to new and young companies because it shows the most honest picture of a company’s health. The cash flow statement takes what’s in the income statement, disregards certain expenses that don’t necessarily involve cash, and adds in many other costs and sources of cash that are not included in the income statement, including cash from investors or loans, and cash paid for start-up costs.

Balance Sheet: Whereas the income statement and cash flow statement show what’s happening over a period of time, the balance sheet shows the end result. If you make money over a certain period of time, the resulting amount of cash shows up in the balance sheet. If you borrow more over a certain period of time, then the resulting total amount of debt shows up on the balance sheet. There’s more to the balance sheet, and your bookkeeping software or your accountant can help you out with that, but if you understand the relationship above, you’re ahead of the crowd.

Cash and Accrual:

The two fundamental ways in which your business’ activity gets recorded are: cash basis and accrual basis. Cash basis is what most of us are familiar with. When your business gets paid, it counts as revenue in the income statement. When your business pays a bill, it counts as an expense in the income statement. Simple, right? 

The more advanced alternative is accrual basis. In this method, the moment when your business pays a bill or the moment when it gets paid doesn’t necessarily affect the company’s income statement. Instead when your company earns income and when it uses the value it derives from expenses are when these transactions are counted in your income statement. Accrual basis is used because the timing of cash transactions doesn’t always show the full picture. Consider the following example:

A caterer takes a deposit of $500 on a wedding that will take place a month from now.

If the caterer is using cash basis, it would record the revenue it earns from transaction the day it receives the deposit. But in cash basis, the fact that the caterer still has a responsibility to cook and prepare for the event in a month from now is not represented on the income statement. Your choice between cash and accrual basis comes down to this: cash basis is easy to implement and works in many situations, but if you find that there is a substantial gap between when your company earns income, pays for expenses, and gets paid, then it might be worthwhile, for planning purposes, to switch to accrual basis.

Receivables, Inventory, Payables, and Accruals:

For businesses that keep track of their books using an accrual basis, these four terms come together to represent money the business owes and money the business is owed, and help to better manage operations.

Receivables: Accounts receivable, or receivables for short, represents the value of work that has been completed and billed for, but has yet to be paid. The balance of receivables tells you what amount of money you should expect to be paid in the near future.

Inventory: Inventory is the value of goods (either materials or completed goods) that the business has procured but has yet to sell. When inventory is sold it becomes an expense (otherwise known as cost of goods sold).  Keeping an eye on inventory can tell you many things like: when it’s time to reorder, how good the company is at selecting inventory, and is an early indicator of potential growth or decline in sales in the future.

Payables: Accounts payable, or payables for short, is the value of goods or services that the company has used but has yet to pay for. Should you be lucky enough to get credit from your vendors, payables are a great way to manage your business’ cash flow. More fully utilizing the payment terms that your vendors give to you helps to free up cash for the rest of your operation.

Working Capital:

Working capital is essentially your business’ reserve of liquid assets available to pay for the cost of ongoing operations. In practical terms, it means the resources (like cash) to pay bills while waiting to get paid. You can find out how much working capital you have by looking at your balance sheet, finding the figure for “Total Current Liabilities” and subtracting it from “Total Current Assets”. 

The amount of working capital your business needs might be completely different than what it has. Startups need two types of working capital. First, they need temporary working capital to fund losses accrued until the business breaks even. Second, they need a residual amount of permanent working capital to fund ongoing operations like all businesses.

Retained Earnings:

Retained earnings is an item that you might notice on your balance sheets and wonder where it came from, since it wasn’t a figure you directly inputted. Retained earnings is basically the magic number that makes the balance sheet balance (makes total assets equal to total liabilities plus total equity). What it represents is the net value of all profits that have been kept in the company versus paid out, since inception. Together with the total amount of cash you and investors put into the business, this represents the value of all equity owners’ stake in the business, if the company were to shut down, sell all its assets, and pay all its debts.  If your business has negative retained earnings, it means that you’ve been funding losses by securing new investments or debt.

Profit Margins:

Profit margins give us an apples-to-apples comparison of different profit figures to help us gauge how “good” or “bad” they are. Whereas $10,000 of annual net profit might be extremely good for a company making $50,000 in revenues, it would be quite low for a company making $1 million per year. In contrast to this, a 10% net profit margin has the same meaning for companies of any size. Profit margins are expressed as percentages, and are obtained by dividing profits by the amount of revenue in the same period of time. Two key profit margins include:

Net Profit Margin: Sometimes referred to as “the bottom line” the net profit margin is a measure of how effectively a company turns sales of goods or services into profits that can be used to pay investors, or alternatively, the number of cents of every dollar of sales that becomes profit for investors.

Gross Profit Margin: Gross profit margin is a measure of how effectively the business’ sales cover the directly-involved costs associated with their business (like inventory and materials). The gross profit margin also tells us how much money we have to work with to cover the rest of our expenses to break-even. The gross profit margin can be easily be used to calculate our monthly break-even sales volume by taking our monthly operating expenses and dividing them by the gross profit margin.

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