What Accounting Principles do You Need to Know to Get Started?
There's no escaping it. You will have to grasp a few basic accounting terms in order to manage your business efficiently. Here are the basics.
ASSETS AND LIABILITIES
Assets and liabilities are fundamental elements of your business. Assets are your “pluses,” the things your business owns and is owed—for example, cash, real estate, inventory, accounts due, other property like patents or trademarks, and prepaid expenses—costs that are paid in advance such as taxes and insurance. Long-term assets such as buildings, equipment, or property that are not expected to be converted to cash are known as fixed assets.
Liabilities are your “minuses,” the business obligations or things that are owed—for example tax payments, repayments to investors, money owed to banks. Also included in the liabilities column—although they're not actually liabilities—are owners' equity (the amount invested by the owners in the business).
Work With a Balance Sheet
How do assets and liabilities apply to your business? Assets and liabilities figure into several financial reports, most prominently, the balance sheet—a snapshot of your business at a given time. A balance sheet is commonly required when you seek funding or loans. It also gives you a snapshot of your business at any particular moment—think of it as taking your business's blood pressure. If you use a software accounting program, generating a balance sheet is just a matter of a few mouse clicks. A balance sheet adds up the assets and liabilities in two separate columns. As the name implies, the columns must balance, that is they should equal each other.
LOOKING AT A BALANCE SHEET
A balance sheet is a snapshot in the life of your business—just one financial moment preserved. It's one of several financial report cards that a business prepares. Sometimes it's referred to as a “Statement of Financial Condition.”
EQUITY AND DEBT
Outside of sales revenue, the two common ways that cash comes into a business are equity and debt – investments and loans. Equity is the money or property invested and retained in the business by the owners (also sometimes referred to as ‘owners' equity'). If you don't properly track and account for equity, you will have tax problems and angry investors.
Debt—the loans, lines of credit and other borrowing you've done—refers to money that must be repaid usually with interest over a fixed period of time. If you don't properly manage debts the lender will foreclose on the loan, sometimes leading to a business bankruptcy.
ACCOUNTS RECEIVABLE AND ACCOUNTS PAYABLE
Accounts Receivable are amounts you are owed from sales of your products or services. Some retail businesses, since they receive payment immediately, have little or no accounts receivable. Accounts Payable are amounts you owe to vendors and suppliers, as well as any other short-term bills—for example payments for inventory, supplies or other goods or services. Loans and similar interest-bearing debts are not included in accounts payable.
Monitoring receivables and payables is a key element in cash flow management. As a general rule, your cash flow is stretched the longer you must wait for your accounts receivables. Conversely, you'll generally have less cash on hand if you pay bills (accounts payable) before they are due.
In order to avoid the mistake of looking at a payment and guessing at your profit, you should use an income statement. An income statement provides a line by line breakdown of revenue and the various sums that are subtracted from the revenue to determine profit. (Most accounting software programs will generate similar statements of profitability.)
The top line in an income statement is the total sales revenue (or “gross income”). That's followed by the sales costs—the direct costs involved in producing the items that are sold (also known as cost of goods sold, CGS or COGS). For example, if you are a book publisher, these costs might be the costs of paper and printing or the costs to pay a writer to create the book. When you deduct the cost of goods from total sales revenue you get the “gross profit.”
Getting to Your Operating Income
The next lines are a series of operating expenses—for example: expenses associated with running your company, known as the general and administration costs (or “G&A”), and expenses associated with sales, marketing, and product development. When you subtract these operating expenses from your gross profit, you get your “operating income.”
A company next subtracts interest on debt and arrives at an amount referred to as its “income before taxes.” After taxes are subtracted, the income statement shows “net income from continuing operations,” and then finally, after subtracting all its expenses listed above and any one-time losses (for example, a legal judgment) from its total sales revenue—the final number is considered the “net income.”
CASH FLOW STATEMENTS
Some call it a cash flow statement, some call it a statement of cash flows and some just call it a cash statement, but no matter what it's called, the purpose is the same: to report your cash on hand and enable you to forecast your cash in the future.
A cash flow statement summarizes all the cash coming in and going out of a business during a specific period by analyzing cash in three classes: operations (sales and operating expenses), financing activities (loans and equity), and investing activities (ownership of real estate, securities and non-operating assets).
But is a cash flow statement really as helpful as it sounds? Cash flow statements can be difficult to understand at first, but once you have studied them, they become clearer. I know of several business people that have a hard time, but explanations from their accountant, each time, at least for a couple of accounting periods, really helps.
Interpreting Cash Flow Statements
In other words, the challenge with cash flow statements—like many financial reports—is that they are difficult to interect. We recommend that you review monthly statements such as cash flow statements periodically with your bookkeeper or accountant. Once you understand how to read them you can efficiently get a pulse on the movement of cash, accounts receivable and bank balances.