The Key Small Business Accounting Terms You Need To Know
Business terms can be confusing…especially when it comes to accounting business terms. Terms like accounts payable and accounts receivable don’t typically come in normal conversation. If you’re just starting to take accounting seriously in your business, it can feel like learning a new language.
But while you may not be familiar with accounting business terms, you can get caught up to speed quickly. All accounting is regulated by and should be done according to GAAP or Generally Accepted Accounting Principles. GAAP can be thought of as a general bucket of rules surrounding accounting and the management of your financial activities.
Further, in the United States and most of the world, accounting is done under the double-entry system, whereby every entry into your accounting records must have a debit and a credit.
GAAP is like the language of accounting. Now let’s get into the actual vocabulary. Here are the key business terms every owner needs to know.
General Business Terms
For starters, let’s define the key accounting terms that everyone will encounter. Whether you’re a sole proprietor or you’re the CEO of a Fortune 500 company, you’ll need to understand these business terms.
Accounting software will take care of the General Ledger for you. But it’s still a good idea to understand this basic accounting info. It will give you a greater understanding of the inner workings of your business finances.
In this video, they are using the example of a non-profit, but the concepts are the same for both non-profits and for-profit companies.
To summarize the video, your general ledger is the master set of accounts that lists all of your business’ transactions. When you’re using the double-entry system as mentioned in the introduction, every transaction will be recorded twice in your general ledger–once on the debit side of the ledger and once on the credit side.
It’s important to point out that in the accounting world “debit” and “credit” mean completely different things than what they mean for consumers.
- For accounting purposes, you’ll record a debit entry whenever an asset or expense is increased and whenever liabilities, equities, or revenue are decreased.
- On the flip side, you’ll record a credit entry whenever an asset or expense is decreased and whenever liabilities, equities, or revenue are increased.
For example, let’s say you receive a $500 payment for an invoice.
- You’ll record that on the debit side (left-hand side) of your ledger as a $500 increase to your “Assets” (e.g. your checking account.)
- And on the credit side (right-hand side) of your ledger, you’ll record a $500 increase to your “Revenue” account. The transactions balance out.
Let’s take a look at one more example. Let’s say you buy $500 worth of office equipment.
- In that case, you’d have a $500 increase in “Expenses,” so that would be recorded on the debit side.
- And you’d also have a $500 decrease in “Assets,” which would be recorded on the credit side. Once again, the transactions balance out.
The balance sheet is one of the most important financial statements that business owners and accountants use. The balance sheet provides a snapshot view of what your business owns (assets) and what your business owes (liabilities) at a certain point in time. The information on your company’s balance sheet can be especially important if you’re trying to secure a loan or an investment.
It’s important to note that the balance sheet doesn’t cover a period of time. It is a snapshot of your balances on a single day.
Assets are anything that your business owns that has value. Cash would certainly be an asset. But you may have several other types of assets as well.
- If you own the building that you do business out of, that is an asset.
- If you own land or equipment that has value, those are assets as well.
You’ll want to make sure that the sum total of all your assets is listed on your balance sheet.
In addition to your assets, your balance sheet will also need to list your liabilities. Liabilities are simply any type of money that your business owes.
- Any business loans or mortgages would be considered liabilities.
- Accounts payable would as well.
- And finally, income and property tax are considered liabilities.
Often, businesses will separate their liabilities into two types — current and long-term.
- Current liabilities are any expenses that need to be paid within the next year.
- Long-term liabilities are debts that are paid over a longer period of time, like a mortgage for example.
The third section of your balance sheet will be dedicated to the owner’s equity (or net worth). If you’re a sole proprietor or partner, this section is very important. It shows what your business is really worth to you at any given moment.
To determine your owner’s equity, you simply subtract your liabilities from your assets. Let’s say you have $100,000 in assets and $70,000 in liabilities. In this case, your owner’s equity is $30,000.
$100,000 (assets) – $70,000 (liabilities) = $30,000 (Owner’s Equity)
Profit & Loss Statement
Your Profit and Loss Statement (sometimes called income statement) shows you if your business made money or lost money during a certain period of time.
While your balance sheet focuses on assets and liabilities, your P&L looks at your revenue and expenses. Profit and Loss Statements can be produced for the month, quarter, or whatever time period you choose.
With accrual accounting, your income statement reports transactions based on when they’re earned. For example, you would record revenue when you invoice a client.
In cash basis accounting, P&Ls and balance sheets report transactions when cash is actually spent or received. For example, you wouldn’t record the revenue until your client actually paid their invoice.
The first section of your P&L will be dedicated to any money that your business received during the period. Typically sales will provide the majority of your income. However, your business may have other income too, like interest payments from Certificate of Deposits or other investments.
This business term is pretty straightforward. Any money that you spent during a specific period of time will be listed as an expense. You can break up your expenses into as many categories as you like, but payroll, inventory, advertising, and taxes are a few examples.
Once you’ve added up all your expenses, you’ll subtract that number from your revenue to find your net income. For example, if you had $30,000 in revenue for the month of February and $20,000 in expenses, your net income would $10,000.
$30,000 (revenue) – $20,000 (expenses) = $10,000 (Net income)
If you had $40,000 in revenue and $50,000 in expenses for your first quarter of business, you would have a net loss on your P&L of $10,000.
$40,000 (revenue) – $50,000 (expenses) = $10,000 (Net loss)
Cash Flow Statement
The cash flow statement shows how much cash went in and out of your business over a certain period of time. Your cash flow statement shows you, the business owner, as well as potential investors how well your business is managing its cash position.
While a cash flow statement may seem similar to your Profit and Loss Statement, they are different in how they handle credit transactions.
For instance, during the month of January, you may have had $100,000 in sales, of which $50,000 were made via credit card. Since you won’t receive the cash payment on the credit card transactions till February, they would not count as income on your January cash flow statement. So your cash flow statement income would show $50,000, while your P&L would show income of $100,000.
In the same way, you may purchase a $10,000 piece of equipment with a credit card or a business line of credit. Until you start making actual cash payments on the purchase, it will not affect your cash flow statement. But it will show up on your income statement (P&L) in the month that the purchase is made.
It’s important to point out that the major differences between cash flow statements and income statements only apply to accrual accounting. With a cash accounting system, revenue is recorded when cash is received, not earned.
Accounts Payable lists all the money that you owe suppliers or contractors for goods or services that they’ve provided.
- Your light bill and rent bill would both be listed in accounts payable.
- Bills that you receive from your vendor would be listed in accounts payable as well.
As accounts payable bills are received, they’re recorded as an increase in expenses on the debit side of your general ledger and as an increase in liabilities on the credit side. As bills are paid, they’re recorded as a decrease in liability on the debit side of your general ledger and as a decrease in assets on the credit side.
In many cases, you may have a separate Accounts Payable ledger that you will record the transactions in as well. Once again, it should be mentioned that Accounts Payable (and Accounts Receivable) is only used and reported on with accrual accounting. With cash accounting, a bill isn’t counted as an expense until it’s paid.
Accounts Receivable is a list of all the money that you are owed for goods or services that you have provided.
If you keep a separate Accounts Receivable ledger, you’ll want to include key information like invoice number, date, and a description of the goods or services that you provided. If all of your invoices have been paid, your Accounts Receivable ledger should have a balance of zero.
Retail Business Terms
Here are a few terms that you’ll want to know if you a product-based business.
Cost of Goods Sold
Your Cost of Goods Sold (COGS) is how much it cost you, in total, to produce a particular product. COGS should include material costs as well as labor. But you wouldn’t include costs like your utility or rent payments or your advertising.
In just a moment, we’ll take a closer at how inventory fits into your COGS formula. Cost of Goods Sold is very important because it helps you decide what price to set your product at if you want to maintain a healthy profit margin.
Let’s say that you begin the year with an inventory of $10,000 worth of product. Then let’s say that throughout the year, you buy $5,000 more in inventory. And at the end of the year, you’re left with $5,000. Here is how you would find your COGS.
$7,000 (beginning inventory) + $5,000 (additional purchases) – $3,000 (remaining inventory = $9,000 (COGS)
Now that you know exactly how much it cost you to create your products, you can calculate your gross profit or loss.
Gross Profit or Loss
To find your gross profit or loss, you simply subtract your COGS from sales.
To continue the example above, let’s say you brought in $59,00 in sales. In that case, your gross profit would be $50,000.
$59,000 (sales) – $9,000 (COGS) = $50,000 (gross profit)
If your COGS is higher than your revenue, you will have a gross loss. It’s important to point out that you can have a gross profit and still have a net loss once overhead like shipping, advertising, and other expenses are taken into account.
Investing Business Terms
Here are a couple of business terms that relate specifically to investment opportunities.
Capital is simply money that you or someone else gives to help a company grow. In many cases, capital investments will, in fact, be cash. But real estate, buildings, and equipment can all be capital investments as well.
Return on Investment
Return on Investment (ROI) is a key metric to help you determine how well an investment has performed. Below, is a basic ROI formula.
ROI = Net Income or Investment Gain / Cost of Investment
Let’s say you bought a building for your company that at the time was worth $500,000. Ten years later, the building is worth $750,000. That’s a net investment gain of $250,000. Let’s take a look at your ROI.
ROI = $250,000 / $500,000 = 50% (.50)
At first glance, a 50% ROI sounds great. But remember, you had to hold on to the investment for 10 years to earn that ROI. That’s why it can be helpful to consider your annualized return too. In the example above, the annualized return is 4.14%. Use an annualized return calculator.
Fixed Assets Business Terms
If you own tangible assets like buildings, plant, or equipment, there a few more business terms you’ll want to know.
Fixed assets are assets that are for long-term use. The term “fixed” is used because the assets are not going to be consumed or used up.
- While your product inventory is an asset, it’s not a fixed asset.
- You expect your inventory to be sold within a reasonably short period of time.
However, assets like land, buildings, automobiles, and furniture can be used again and again for many years.
If you’re going to use an asset over multiple accounting periods, you can depreciate the expense over time.
For instance, let’s say you buy a $20,000 piece of equipment that you plan to use for 10 years. In this example, you could spread out that expense (for accounting purposes) over the 10-year period, instead of it showing up as one huge expense on your books.
Large purchases like buildings and furniture may be good candidates for depreciation. But purchases of less than $1,000 probably aren’t worth the hassle. And while they are a fixed asset, land purchases cannot be depreciated.
The acquisition costs of a fixed asset takes into account any additional expenses that you may have incurred during the purchase.
- For instance, let’s say you buy a building for a sales price of $300,000.
- But you also spent $50,000 in real estate commissions and closing costs.
- In this case, your acquisition costs would be $350,000.
This is the number that you would use for depreciation purposes.
Good accounting can help you identify trends earlier and make better financial decisions for your business. Profitable businesses are built upon strong account principles. Understanding the key business terms that we’ve covered in this guide can be your first step towards establishing those principles in your own business.