As Warren Buffet says, accounting is the language of business.
He and other savvy business owners use accounting to make investment decisions and decisions to grow the businesses they invest in. But interestingly enough, many small businesses often neglect their accounting until tax time, or don’t do it all.
9 out of 10 small businesses that fail, fail due to financial mismanagement of their company.
Their financial mismanagement may result in their failure to make decisions to grow their business, meet financial obligations like paying employees or their rent, miss tax deductions that can save them money, or fail to pay their taxes all together.
Look, I get it. As a CPA that studies and practices accounting, I know that accounting isn’t the most exciting thing in the world. And, it’s probably not why you decided to go into business for yourself.
You probably have a very good product or service that you’re very passionate about. And your offering will delight customers and beat the competition.
However, eventually, you will be faced with the reality of accounting. And it’s best that you’re prepared for it now so you don’t suffer consequences later.
In this post, I’m going to simplify the accounting basics for small business owners. By the end of this post, you will know the what, why, and how of accounting.
With that said, let’s begin.
What is Accounting?
Like really, what does accounting mean?
Accounting is the process of recording, reporting, interpreting, and analyzing financial information.
These words – recording, reporting, interpreting, and analyzing are very important. And I am going to break down each component of this definition in a moment.
But let’s first discuss why accounting is important.
Why is Business Accounting Important?
To understand why accounting is important, it is best to look at a simple example.
For example, let’s say that you own a cleaning company. We’ll call it The House Cleaning Company.
Let’s say you charge $100.00 to clean one person’s house. And that includes vacuuming, carpet cleaning, window wiping, and more. At the time, you just started your business, so you decide to do everything yourself in the beginning.
Fast-forward 2 years later, and all of sudden your business is booming. Your phones are ringing off the hooks. Your schedule is completely full for the week. And you don’t have time to do anything – sales, customer service, delivering the cleaning services, and so on.
Now, you’re stressed and don’t know what to do.
Logically, this is a good problem to have. Your business is growing, and perhaps you just need to hire some people to help you at this point.
So you decide to do this, and now you need to make some tough decisions.
For one, who do you hire first? How much do you pay that person? How can you make sure there is enough work for that person to do? And most importantly, how much can you afford to spend to hire that person? And how much can you afford to spend to keep expanding the business?
Now there are a few things that will help you in making this decision, such as knowing:
- your profit margin,
- how much cash you have available,
- and your current financial obligations (debt and expenses)
If these things are absent, you are unable to make informed decisions to grow and scale your business.
And, if you make the wrong decisions, it can be detrimental to your business. For example, what would happen if you hired someone but they didn’t have enough projects to work on? Now you’re wasting money on that person.
Or, what would happen if your customers don’t pay you on time and you don’t have enough cash to pay your vendors? Now you can’t operate your business.
Or what does it take to expand your business? How much can you afford to spend in marketing or service improvements?
Whatever you decide to do, there will likely be a financial implication. In other words, it will cost money.
And if you do not understand how money is currently flowing in and out of your business, you risk making ill-advised decisions that can cause your business to fail. You also risk tax consequences by missing business deductions that can save you money on your tax bill.
Now, you can save yourself from these financial headaches by having a reliable accounting system in place from the very beginning.
So let’s discuss the accounting process that you need to deploy in order to accomplish this.
The Accounting Process for Small Business
Earlier, we broke down the accounting process into 4 simple steps – recording, reporting, interpreting, and analyzing are very important.
Let’s go over these steps.
The first part of the accounting process is to record all transactions that occur in your business.
Every time a transaction occurs, you must record it.
Now there are 5-major types of transactions that you must know. These 5 transaction types are:
Revenue, Expenses, Assets, Liabilities, and Equity.
It is important that you know what these 5 transaction types are because it will determine how your reports are organized and influence how you interpret your business finances.
Here’s a very easy to understand breakdown.
a. Revenue is what you make from selling your products or services.
It is the value customers pay in exchange for your products or services. For example, when a customer paid The House Cleaning Company for its cleaning services, their payment represents revenue. Revenue is also commonly referred to as Sales.
b. Expenses, on the other hand, are costs incurred to run your business.
In the cleaning example, my expenses would be the cost to hire a contractor and cleaning supplies used.
c. Assets are resources that are owned by the company with a measurable future value.
For example, if I owned an expensive cleaning device, such as a carpet cleaner, this would be an asset in my business. Anything that you own that is used to generate future value is considered an asset.
d. Liabilities are what the company owes to creditors.
For example, if I took out a loan to pay for my expensive cleaning device, then I would also have a liability to pay that loan back later. In this scenario, I would gain an asset, the cleaning device, and a liability, the loan.
e. Equity is the degree of ownership in your business.
Your equity is the difference between your assets and liabilities. Or, in other words, it is the difference between what you own vs what you owe.
Now, the most fundamental part of accounting is recording and categorizing each transaction that comes into your business into one of these categories.
There are quick and easy ways to do this by syncing your business bank account to a bookkeeping system, and classifying your transactions within that system.
This process is called bookkeeping. To learn more about bookkeeping, then read this post on “Bookkeeping 101 for small businesses”.
Now let’s move on to the 2nd major component of accounting – reporting
Once your bookkeeping is complete, you will be able to prepare financial reports that depict the financial health of your business.
There are three major accounting reports that every small business should be familiar with.
Your income statement, balance sheet, and cash flow statement.
a. Income statement is where you can find your total revenues, expenses, and most importantly – profit. Your income statement tells you if your business is growing or slowing, and if your business is in the “green” or not- which refers to if your business operations are profitable.
You can view your income statement in two formats – on a cash basis or accrual basis.
- Cash basis simply means that you recognize revenue and expenses based on when money is exchanged. For example, let’s say that you paid $100 to reserve my cleaning service. But, I won’t deliver the cleaning service to you until next month. Well, under cash-basis accounting, the revenue would be recognized the moment you paid me, not when I delivered the service.
- Accrual-basis, on the other hand, means that you recognize revenue and expenses based on when the exchange is complete – or in other words, once the service is delivered. Under Accrual-basis accounting, revenue must be EARNED by exchanging the product or service. It ignores the cash transaction.
To learn more about the differences between this, and when to use either, please check out our post on “Accrual vs. Cash-Basis Accounting”.
b. Balance sheet shows which assets the company owns, the liabilities it owes, and the equity that belongs to the owners. The balance sheet helps you understand your company’s liquidity and ability to meet its financial obligations.
For example, if my cleaning company has $20,000.00 in assets, but $15,000.00 of those assets are not liquid- like equipment for example, that would mean I only have $5,000.00 in cash. This could mean trouble if my expenses began to exceed the amount of cash I have in the bank.
Even worse, if my cleaning company has a high “Debt-to-Equity” ratio, it could indicate that my business is overleveraged and could have issues paying my liabilities if a downturn occurred in my business.
As you can see, your balance sheet can give you a clear indication of the financial health of your business.
c. Cash flow statements dig deeper into the cash position of the company.
It details all of the cash outflows and inflows on a consistent basis.
For example, you may have debt payments and expense payments. But, both of these transaction types show in different reports. Your debt standing is reflected on your balance sheet. Your expenses are reflected on the income statement.
The cash flow statement shows the total amount of cash leaving your business, regardless of it is an expense or liability.
This statement helps you understand the total outflow of cash each month, which enables you to make healthy decisions about future projects that require cash.
As you can see, these reports can give you a good idea of what’s happening in your business. Knowing this information can help you make future decisions to grow your business.
3. Interpreting and Analyzing
Unfortunately, financial reports mean nothing if you cannot interpret them.
And, there are many ways to slice and dice through your financial reports to derive certain information. In many cases, you can apply ratios to certain pieces of your financial statements to interpret what’s really happening in your business.
For example, on the income statement, you can find out your profit margin by dividing your net profit by sales. You can find out your return on advertising spend by dividing your advertising expense by your sales revenue.
On the balance sheet, you can find out how liquid your company is by using the current ratio, which divides current assets by current liabilities. You can also find out how quickly your customers pay you by using the accounts receivable turnover method, which divides your sales on the income statement by your accounts receivable, which is the money people owe you.
As you can see, there are several ways to interpret and analyze your financial statements. And to be honest, there are hundreds of ways to analyze your financial statements.
I know this because of all the years and exams I had to take to learn it. To get the best interpretation of your financial statements, you may need to invest into some financial analysis courses or consult a CPA. We’d be happy to help you with this process through our bookkeeping, tax planning, or CFO services.
Anyway, us aside, let’s summarize this post so you can walk away with the accounting basics for small business.
We started this post by defining accounting. Accounting is the simply the process of recording, reporting, interpreting, and analyzing financial information.
Then, we discussed why accounting is important. Accounting is so important because it helps you make decisions to grow your business and prevents financial mismanagement that can result in financial stress, headache, or closure of your business.
Finally, we broke down each element of accounting – recording transactions, financial statement reporting, and how to interpret and analyze financial information.
While there are many ways to report and analyze your finances, there is only one way to get started. You must start recording and categorizing every financial transaction that occurs in your business. To pull any report or conduct any analysis, you must first have a bookkeeping system in place.
For your bookkeeping, accounting and all other financial management needs, LYFE Accounting is here ready to help. Contact us today to get started!