Accounting is the process of recording and reporting financial transactions pertaining to a business.
While it is advisable to make use of accounting services, it is important for entrepreneurs to know and understand certain basic business and accounting terms for the benefit of their business and decision making.
We’ve prepared a list of fundamental accounting terms every entrepreneur should know.
Knowing these terms will help you better understand your small business so you can confidently speak to lenders, investors, and your management team.
Accounts receivable
This is the money due to your company, it is the amount of money that your business is owed by your customers for goods and services that you supply. This total value can give you a snapshot of the amount owed to your business at any given time. Watching this number closely will help you determine which customers are paying in a timely manner and which accounts need some extra attention.
Accounts payable
This is the money owed by your company, it is a measure of how much you owe your creditors for goods and services that they supply to you. It is important to know how much your business owes in the short term so you can manage your cash flow to ensure bills are paid on time and good relationships are maintained with suppliers.
Accrual vs cash-based accounting
Accrual-based accounting tracks income when it has been earned on the date of sale (you created an invoice) and expenses when it has been incurred (you receive a bill), whether or not money changed hands. While cash-based accounting includes income and expenses only when customers make payments or vendors are paid. As a business owner, you need to verify with your regulatory bodies such as with the revenue services whether your business is required to report using the accrual or cash-based accounting method.
Assets
This is any resource that is owned by the business, it can be anything tangible or intangible that is owned or controlled to produce value and used by the company for producing positive economic value. These are usually classified as current or fixed. Current, or short-term, assets include cash or inventory. Fixed, or long-term assets, include equipment or land.
Note: Not all assets are physical tangible goods because things like patents and copyrights and trademarks are also valuable parts of your business as intangible assets.
Balance sheet
This key financial document, also referred to as the statement of financial position, provides a snapshot of business assets, liabilities and owner’s equity. This statement should reflect your company’s assets, liabilities, and capital at a specific time. This statement is important for potential investors to determine amongst other things the liquidity of your business and how much your business owes and owns.
Bootstrapping
Many small business owners have “bootstrapped” the funding of their business. This means that they invested their own money and used personal credit to pay for business expenses as it ramps up to be self-sustaining. Business owners choose this method to avoid debt or because they are unable to get business financing.
Break-even point
A business's break-even point is when its total revenues equal its expenses. This number is important to know so that you understand how much revenue is needed before you start making a profit.
Business credit
A business’ credit score becomes more important as the business grows and requests approval for leases, larger business loans, and letters of credit.
Capital expenditure
Capital expenditure refers to money invested in an asset that provides ongoing benefits. This would be something like your vehicles, equipment and other large expenditure that should provide earning capacity over several years.
Cash disbursements
This is any outgoing cash payment that is made for things that are related to the business’ operating expenses. Some examples of cash disbursements are interest on loans, inventory expenses, wages, rental costs, etc.
Cash flow
Cash flow is the movement of money in and out of your business. You to have a higher flow of income into the business than there is an outflow of expenses from the business. This is called positive cash flow.
Cost of goods sold (COGS)
The total direct cost to produce and sell your goods. This total should include all direct labor, materials and supplies and any overheads you incur.
Depreciation
When a business buys an asset, the asset has a useful life expectancy before it must be replaced due to wear and tear. Instead of assuming that the asset retains the same value throughout its life, depreciation reduces the value incrementally each year.
Dividends
A dividend is a share of profits and retained earnings that a company pays out to its shareholders. When a company generates a profit and accumulates retained earnings, those earnings can be either reinvested in the business or paid out to shareholders as a dividend. The annual dividend per share divided by the share price is the dividend yield.
Expenses
This is the money you spend to operate your business. Examples include equipment expenses, wages, rent utilities and inventory.
Equity
It is the value attributable to the owners of a business and is equal to the net balance of your business’ assets reduced by its liabilities. In other words, it is the excess value of your business assets that is above the value of the business liabilities. You have negative equity if your company has more liabilities than assets.
Financial statements
This is mainly the combination of the business income statement, the statement of cash flows, the balance sheet and the statement of changes In equity.
Fixed costs
A fixed cost is an expense that does not change over the short term. The fixed costs of a business are the expenses you will incur whether you produce or sell any items or not. Examples of fixed costs include rent, salaries, and insurance.
Gross profit
Not to be confused with your gross margin, gross profit is the amount found from net sales minus COGS.
Gross margin
A percentage value found from the difference between your revenue and COGS.
Income statement
Sometimes referred to as the Profit & Loss statement, your income statement reflects your financial performance over a certain period of time. It includes all revenue and expenses and any net profit or net loss over the same period of time.
Inventory
Inventory is the value of finished goods that a business has available for sale. Inventory is recorded as assets on the balance sheet. When items are sold, they are removed from inventory, then counted toward the cost of goods sold.
Liabilities
Liabilities are debts your business owes another person or entity. Like assets, you’ll have to define liabilities as current or long-term. Current, or short-term, liabilities might include an expense payable to a supplier. Many business loans are long-term debts. You should try to keep this in consideration as it will spell a problem for stakeholders and investors of your company.
Net profit / bottom line
Your bottom line is the number that reflects your current financial results. Net profit represents total revenues less total expenses.
Net loss
If your total expenses exceed your overall revenues, you have a net loss. The risk of a net loss is one of many strong reasons to keep company costs under control.
Operating costs
Operating costs are the ongoing expenses of a business that are part of its normal functions. These expenses include the cost of goods sold and operating expenses, such as sales expenses, travel, bank service charges, office supplies, utilities, and rent. Operating costs cannot be avoided and include both fixed and variable expenses of the business.
Overhead
Overhead refers to the non-labor expenses required to operate your business. These expenses are not linked to the manufacturing of a business's products or providing services. Examples include rent, insurance and utilities. Overhead expenses should be reviewed regularly in order to increase profitability.
Owner’s equity
Owner equity represents the owner's net investment in the business since the company began. Subtract liabilities from assets to calculate owner's equity. The number increases when the company makes a profit or the owner contributes money or assets to the business, and it decreases when the company loses money or the owner makes a withdrawal from the business.
Profit margin
A profit margin is the measure of a company's profitability. It represents what percentage of sales has turned into profits. There are different types of profit margins such as the gross profit margin, operating profit margin and the most common, the net profit margin. Net profit margin is calculated by dividing the net profits by net sales. Business owners try to increase their profit margin by increasing prices, selling more items or services, and reducing expenses.
Recurring revenue
Any portion of your revenue that is likely to continue or repeat.
Return on investment (ROI)
This is a benefit to a shareholder for investing in your business. What investors want is a high ROI. Calculate ROI by dividing net profit by the cost of the investment.
Revenue
Revenue refers to the income you get from a business activity (providing goods or services) in a given time. You can calculate earnings by multiplying the per-unit sales price of goods or services by the number of units sold.
Trial Balance
A statement or report that lists all income statement and balance sheet balances you hold (debits or credits), noting anything without a balance of zero. This should help catch any accounting errors as debits must equal credits.
Variable costs
Variable costs are the expenses that increase and decrease based on the number of items produced or sold by your business. Examples of variable costs include sales commissions, raw materials, direct labor costs, and utilities.
Working capital
Working capital measures the short-term financial health of your business. This measures the ability of your cash to cover the ongoing commitments of the business.
Working capital ratio
The working capital ratio or current ratio measures a company's efficiency and the health of its short-term finances. The formula to determine working capital is the company's current assets divided by its current liabilities. The working capital ratio reveals whether the company has enough short-term assets to pay off its short-term debt.
