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As a small business owner, one of the first things you should do is make sure you have a basic understanding of key accounting terms.
Do you speak accounting? A good bookkeeper or accountant can explain your business’s financial position to you in plain English, so fluency in accounting isn’t mandatory, And that’s a good thing! After all, you didn’t start your business so you could go get a degree in accounting in your nonexistent spare time.
However, just as it’s a good idea to know some key words and phrases when traveling to a foreign country, it’s also wise to understand some basic accounting terms for small business before meeting with your financial advisors. That way nothing is lost in translation, making your meetings more productive and enjoyable.
Following is a list of 11 basic business accounting terms every small business owner needs to know before venturing into the wilderness known as the accountant’s office.
Accounts receivable is money owed to you. Accounts payable is money you owe to others. That seems simple enough, but these two terms often throw off small business owners. Do you ask for accounts payable or accounts receivable when you need to speak to a customer about a payment owed to you? How about when you need to discuss a bill you owe to a vendor?
The best way to keep these two terms straight is to remember that one man’s payable is another man’s receivable. If you are calling about money owed to you (your accounts receivable), you need to speak with your customer’s accounts payable department. Likewise, if you are calling one of your vendors to negotiate terms on an invoice (your accounts payable), you need to ask to speak with their accounts receivable department.
Keeping this rule of thumb in mind will save you valuable time when communicating with your customers and vendors (not to mention save you from the embarrassment of asking for the wrong department).
This is an incredibly important small business accounting term. Simply put, your business’s burn rate is the rate at which your business spends money. This is obviously an accounting term you need to know—and know well.
Calculating your burn rate is simple: Pick a time period—usually a quarter or longer—and subtract the cash you have on hand at the end of the period from the cash you had on hand at the beginning of the period. Divide this number by the number of months in the period, and you have your burn rate.
For example, let’s say you had $12,000 in the bank at the beginning of the quarter, and at the end of the quarter your bank balance is $6,000. This means over the three month period, you spent $6,000. Dividing $6,000 by three months, you can see your burn rate is $2,000/month.
Knowing how fast your business goes through cash is critical in the management of your cash flow. Ideally, you want to have a negative burn rate, because that indicates you are growing your cash reserves. The exception to this rule is when you are investing in the growth of your business.
Your business’ chart of accounts—or COA—is like a filing cabinet for all your financial transactions. It is a complete listing of every account in your bookkeeping system.
The chart of accounts is an accounting term that helps keep the data in the general ledger (see below) organized in such a way that your financial reports are meaningful. For this reason, business owners should work closely with their accountant or bookkeeper to devise and maintain the chart of accounts.
This is one of the most improtant business accounting terms. Your business’ cost of goods sold (COGS) or cost of sales (COS) is the direct cost of producing your product or delivering your service. Knowing your COGS or COS is the critical first step in determining your gross profit margin.
Let’s say your business produces $1 million in income over the course of the year. That sounds pretty impressive, right? But what if your cost of goods sold is $900,000? This means your $1 million business only had $100,000 after paying for the production of your product. It also means your gross profit margin is only 10%.
COGS or COS is the first expense you will see on your profit and loss statement. Taking steps to reduce this expense will let you automatically increase your overall profit without having to increase sales.
Depending on how your business is organized, you might or might not be on your company’s payroll. Most small business owners, though, take at least a portion of their pay in the form of draws or distributions (the terminology depends on how your business is structured).
It’s of critical importance to note draws and distributions do not appear on the profit and loss statement. These payouts are actually a reduction in the equity (see below) of the business, so they show up as subtractions in the equity section of the balance sheet.
Equity is your ownership in the business. It is a combination of the money and other things of value you have invested in the business plus the earnings the business has retained over its lifetime.
Equity can also be defined as the difference between the business’ assets (what the business owns) and its liabilities (what the business owes).
Sadly, many small businesses have negative equity. This can indicate the owner is taking too much money out of the business, debt is too high, or that the business is not profitable. A business with a healthy equity is, among other things, attractive to potential lenders, investors, and buyers (should you decide to sell your business).
GAAP is the acronym for generally accepted accounting principles, which are the guidelines for proper accounting and financial reporting. GAAP compliance is particularly important in publicly traded companies, but many lenders and investors require GAAP-compliant reports as part of their decision-making process.
A good bookkeeper or accountant does everything possible to make sure your financial statements are GAAP compliant even if you don’t own a publicly traded company or aren’t seeking funding. However, only an external audit, performed by a certified professional (usually a certified public accountant) can guarantee your financial statements are GAAP compliant.
The general ledger is the basis for your entire bookkeeping system. Simply put, it is a record of all the financial transactions in your business, for its entire history. The general ledger is organized by the chart of accounts (see above).
Keeping a backup of your general ledger is very important. In the event of a disaster, your accountant or bookkeeper can help you reconstruct your business’ financial data using the data in your general ledger.
In accounting terms, a liability is a debt your business owes. This could be a credit card balance, a loan, or sales or payroll taxes.
Liabilities appear on the balance sheet—not the profit and loss statement—and they are paid over a period of time by reducing the cash in your checking account and simultaneously reducing the amount due on the liability.
Liabilities are not inherently bad. However, you want to make sure your assets (what your business owns) are greater than your liabilities. Otherwise, your equity is negatively impacted, and you could find yourself in a precarious position should you experience a downturn in sales or need financing to take advantage of a business opportunity.
Profit is a small accounting term that can cause big headaches. The profit on your profit and loss statement is almost never a representation of the cash in your bank account. Every year I get several phone calls from business owners who are sure there is something wrong with their bookkeeping because the profit on their financial statements is either much higher or much lower than their bank account balance.
In bookkeeping and accounting terms, net profit—or the “bottom line” on the P&L statement—is the difference between income, cost of goods sold, and the operating expenses in the business, as well as interest expenses and depreciation. The trick is remembering there are certain cash flow activities – like draws and distributions and debt payments—that don’t appear on the P&L.
You—or your business, depending on tax structure—are taxed on the net profit, not the amount of cash you have left over after paying debt and taking draws or distributions. For this reason, it is critically important you proactively plan for your tax liability by regularly consulting with your accountant and by setting aside a portion of all your income to cover your tax liability. A large net profit isn’t a bad thing—in fact, it’s a very good thing—but not having the cash available to pay your tax liability is very bad indeed.
Return on investment is an analysis of financial performance in relation to money or time invested. This accounting term can be abbreviated as ROI.
For example, let’s say you spend $900 on a sales training program. As a result of this program, you are able to increase sales in your business by $9,000. The gross return on your investment is $8,100 ($9,000 in sales, less the $900 you spent on the training program). Your percentage ROI, though, is 900% (the $8,100 gross return divided by the $900 you invested on the sales training program).
Be aware of the ROI on your major investments of time and money to make sure you are focusing your resources on the most profitable activities in your business.
Knowing these 11 accounting terms does not make you fluent in accounting. However, it will make your conversations with financial advisors—as well as investors and lenders—much easier. Even if you aren’t a numbers person, you may well find you enjoy visiting with your accountant and bookkeeper now that you can speak some of their language.