Today, I’ll be deep-diving into the bookkeeping basics for small business.
And by the end of this post, you’ll understand the importance of bookkeeping and how to properly complete your bookkeeping in just a few simple steps.
You see, here at LYFE Accounting, we handle the books for small business owners everyday and have a time-tested 6-step process that helps small businesses make better financial decisions that lead to greater profitability.
Whether you are a new business owner or a serial entrepreneur, the 6 step process I’m going to share with you will be easy to follow and hard to get wrong.
Ready to learn the bookkeeping basics for small business?
Let’s get started by answering this question first- what is bookkeeping?
What is Bookkeeping and Why is it Important
The textbook definition of bookkeeping is the routine, systematic method of retrieving financial information, categorizing that information, inputting it into an accounting system, and generating reports which are used by decision makers to make better financial decisions for their business.
That’s a mouthful!
More simply, bookkeeping.
Have you ever thought about expanding your business? Of course, you have!
Most business owners would love to grow their business to the next level. But the reason why the majority do not is that they are unsure as to the how. How can you grow your business? The answer is in your bookkeeping and your bookkeeping should be completed every month.
Now that we understand what bookkeeping is and why it’s important, let’s discuss the 6 steps to actually perform bookkeeping.
A Simple 6 Step Bookkeeping Process
Bookkeeping can be broken down into 6 steps. A bookkeeping service is usually responsible for the first 4 steps but you can also do it yourself. The last 2 steps are your responsibility but the fun part.
As stated before, small business bookkeeping is there to help you make decisions.
Step 1: Gather Source Documentation
Source documents are original records containing details of a transaction. Examples include an invoice, sales order, or a receipt. All of these documents have a date, buyer/seller, amount, and product/service provided. This is the information your bookkeeper or yourself need to start the small business bookkeeping process.
In today’s online world, most people don’t keep up with physical copies of all of their source documents. Instead, they rely on their bank statements to tell the story. In most cases, bank or credit card statements have all of the information needed to substantiate a business transaction.
Keep in mind that cash transactions are not recognizable using bank statements alone.
If you have cash transactions, you have to retain the physical receipt or recall the purpose of the cash transaction and communicate that to your bookkeeper if you have one. Your bookkeeper can then correctly classify those types of transactions.
As a tip, it’s good practice to use credit or debit cards to make and receive all payments. This way, you or your bookkeeper can rely mostly on your bank statements to classify transactions making step 1 extremely easy.
Step 2: Categorize Your Transactions
Understanding what is bookkeeping is understanding that every transaction needs to be classified into a specific category. It is the core of the bookkeeping process.
In step 2, you or your bookkeeper will need to categorize your transactions depending on its business purpose.
There are 5 main categories that transactions fall into:
Each one of these categories can be broken down further into subcategories. For example, you could have a subcategory for inventory which would fall under the asset main category.
The first step of categorizing is identifying which main category a transaction belongs to.
Assets are defined as resources that have some future economic benefit. For example, cash would be an asset. It is a resource and can be used in the future to benefit your business.
Liabilities are future obligations. Examples are a payroll liability or a loan from a bank.
Equity is ownership interest. Equity increases with revenue and capital contributions. Equity is decreased with expenses and distributions.
Revenue is generated by the sale of products or services.
Expenses are the costs incurred to generate revenue. Expenses could be the cost of goods sold or supplies.
Most bookkeepers will use an accounting software to help with the organization and classification of transactions. Bookkeeping is no longer a pencil and paper process.
Step 3: Reconciling Your Transactions
A good bookkeeper will correctly classify transactions. A great bookkeeper will reconcile transactions to make sure everything is accounted for.
The idea of reconciling is simple. It is the process of matching all of your transactions on your bank statements to what is in your accounting software. When you or your bookkeeper is dealing with hundreds or even thousands of transactions, it can be easy to double count a transaction or two. Or accidentally miss one.
But reconciling helps to catch all errors.
Start with the beginning balance on your statements (which should match what’s in your accounting program) and check line by line that every transaction is accounted for.
Step 4: Preparing Financial Statements
The last step for a bookkeeper is to prepare financial statements.
The process of adding, classifying and reconciling your transactions provide the inputs for your financial statements.
There are 3 main financial statements that should be prepared: the balance sheet, income statement, and cash flow statement.
1. Balance Sheet
The balance sheet is also known as the statement of financial position. It contains asset, liability and equity transactions.
What makes the balance sheet unique from the other financial statements is its balancing component. Assets on the balance sheet must equal liabilities plus equity. If not, your balance sheet is out of balance!
2. Income Statement
The income statement is also known as the profit and loss statement. It contains revenue and expense transactions. The income statement tells you how profitable you are during a certain period.
3. Cash Flow Statement
The cash flow statement has 3 components:
- cash from operations
- cash from financing
- cash from investments
The cash flow statement shows how transactions from the balance sheet and income statement affect your cash account.
Have you ever heard the saying cash is king? Well, it is true. Investors and creditors want to know if you have cash on hand. Without cash, your business is not sustainable.
Good job! We’ve made it more than half-way through the 6 bookkeeping steps for basics for small businesses.
Ok, let’s move on to the last two steps. These steps are for business owners specifically.
Steps for Business Owners
Step 1: Read Your Financial Statements
So you or your bookkeeper prepared your financial statements. Now what?
Digging into the details of your company’s financial statements may not sound appealing, even for the most financially savvy business owner.
However, businesses succeed or fail based on what their financial statements are trying to tell them. Therefore, it is critical for you to understand your financial statements and take advantage of the insight it’s giving you.
This key action is the difference between you having a more profitable business this year, then you had last year.
In order to read your financial statements, you should understand how they are structured.
Structure of the Balance Sheet
Remember the balance sheet must balance. The assets are listed first and liabilities and equity are listed last.
- Assets are ordered in terms of liquidity or how long it will take for the asset to convert to cash. For this reason, cash is always the first asset you will see on the balance sheet, followed by other current assets (accounts receivable, inventory).
- Long-term assets are listed after the current assets (i.e. equipment). Fixed assets, like equipment, take into consideration depreciation, a contra asset, that would reduce the asset side of the balance sheet. Think of depreciation as the amount of an asset that has been “used up”.
- The liabilities section is listed similarly to assets. Current liabilities appear before long-term liabilities. Current liabilities are debts due within 12 months. Common accounts listed under current liabilities are accounts payable, wages payable and credit cards. Common accounts listed under long-term liabilities are bank loans, car loans, and capital leases.
- The equity section is listed last on the balance sheet. It shows the ownership in the business. It is sometimes referred to as the “book value” or net worth of a business since its value equals assets minus liabilities. Also, retained earnings is a section within equity. Retained earnings are the dollar amount of earnings reinvested in the business.
Structure of the Income Statement
The first component of the income statement is revenue (a.k.a. the top line). It is the dollar amount of product or service sold at a given time. The revenue section may be broken down further into specific types of income based on products or services.
The next item is the cost of goods sold or cost of sales. These are the direct expenses associated with selling your products or services.
Examples are inventory costs and labor.
The difference between the revenue and cost of sales is gross profit.
The other expenses of the business are listed below the gross profit.
“The bottom line” of the income statement is the net income. It is the amount after subtracting all of the expenses of the business. It answers the question, “what is the profit or loss of the business?”
Structure of the Cash Flow Statement
The cash flow statement tracks the cash coming in and going out of your business. These cash inflows and outflows are broken into 3 categories:
Cash flows from operations is the cash activities related to performing the regular, ongoing activities of your business. Activities like selling products or services would be considered cash flows from operating activities.
Cash flows from financing relates to capital raising activities of your business. So if your business borrows money from a bank, that is considered a financing activity. When your business starts repaying the loan, that is a financing activity. Financing activities don’t just relate to loans but equity funding too. So if your business issues stock to investors, that too is a financing activity.
Cash flows from investing relates to the gains and losses from your business’ investments. If your business invests in the stock market, that is considered an investing activity. When your business buys stock in another company, that is an investing activity.
Now, the last and final step for you as a business owner is to MAKE DECISIONS.
Step 2: Make Decisions Based On The Data
One of the most important purposes of bookkeeping is to help you make better, more profitable decisions.
Every day, business owners are faced with decisions concerning all areas of their business. Answering the age-old question, “How can I make more without spending more?”
You now have gained familiarity with the 3 most common financial statements. Now, it’s time to learn how to use these statements to make well-informed business decisions.
The balance sheet outlines your company’s assets, liabilities, and equity. As such, the balance sheet can be used to gauge the liquidity and sustainability of your company.
Let’s take an example of a company who has $1,000,000 in net income. Their balance sheet shows 3 months of income in accounts receivable. Knowing this information, the owner might decide to shorten the collection period to have more cash on hand.
Next, the income statement tells you the operating performance of your company. It lists out the revenues and expenses and spits out a profit or loss.
However, the income statement tells you a lot more than that. The details of the income statement can help you focus on the strengths of your company and improve on its weaknesses. You’re able to see which product/service lines are performing better and how much you are spending in each area.
The cash flows statement tells you how much cash your company has on hand and whether or not it’s staying afloat. It shows if your business is able to pay its debts as they come due which is a component potential lenders and investors are interested in. If your operating cash flow has decreased, then you might reassess some of your operating costs or pricing.
I’ve said it before and I’ll say it again. Bookkeeping is a key action that can be the difference between you having a more profitable business this year, then you had last year.
Simply because you now have accurate financial data to make smarter decisions with.
If you find that you lack the time or knowledge to do your own bookkeeping, consider LYFE Accounting for your bookkeeping basics for small business needs. We provide you with the financial statements you need to make smart, profitable decisions. Talk to us today!