From brainstorming and research to strategizing and finally getting your idea off the ground, starting a small business is a long (and sometimes intimidating) process. And while accounting is an important part of running your business, it probably wasn’t what enticed you to become an entrepreneur in the first place.
Hiring an accountant can take the stress of bookkeeping, payroll, and taxes off your plate so you can focus on all the other things. But delegating financial responsibilities doesn’t mean you should check out of the process. The opposite is true — by working closely with your accountant throughout the year, you’ll have a better understanding of your financial position so you can plan for the future.
The first step to increasing your accounting acumen and financial well-being is understanding some basic accounting terms. Here are 11 small business accounting terms you should know as a business owner:
1. Cash flow
Cash flow is the amount of money moving in and out of your business. If you have more cash flowing into your business each month than you pay out to cover costs and expenses, you are “cash flow positive.”
A company’s ability to have a positive cash flow helps potential investors determine the health of the business. Having excess cash on hand means you’re better equipped to keep up with debt, cover unforeseen expenses and invest in growth opportunities. If the opposite is true (and you have more money moving out of your business), your cash flow statement will reveal that you’re “cash flow negative.”
If tracking cash flow is high on your priority list, ask your accountant if they can generate a cash flow statement each quarter (or month or week) to keep tabs on this key performance indicator. Xero has some really smart cash flow forecasting tools for those that manage their receivables, payables, and payroll through this online accounting software.
2. Profit and loss statement
The profit and loss statement (also known as the income statement or P&L statement) is one of the most important documents used by accountants to figure out the profitability of your business. It breaks down how a business reaches its net income, making it a good indicator of your company’s management and operations.
The P&L statement lists revenues and gains as well as expenses and losses over a specific period of time (annually, quarterly or monthly). It calculates your “bottom line” so you know if you’re operating at a loss or turning a profit.
Are you preparing for the end of the fiscal year? Download this income statement example to help guide you through the process.
3. Earnings before interest, taxes, depreciation and amortization (EBITDA)
The profit and loss statement helps you figure out your net profit. Another common metric that businesses are evaluated on is called EBITDA (earnings before interest, taxes, depreciation and amortization).
To calculate the EBITA, start with your net income and add your interest expense, tax expense and depreciation expense to your total. This creates a more objective, clear picture about how much cash your business actually made before spending money on non-operating items (things that aren’t essential to running your business).
EBITDA helps you do an apples-to-apples comparison of businesses in the same industry. It’s more objective because it removes items that are subjective management choices, but can impact net income. These include:
- Debt (or leverage)
- Tax brackets (may be location or business-structure dependent)
- Depreciation on capital purchases. This is a non-cash figure, and the real number would be the capital expenses needed to maintain operations. Some companies choose to lease equipment or vehicles instead of buying outright. Others may invest more in maintenance and use their equipment longer instead of trading up every few years to get the newest gear.
5. Useful ratios
These are useful ratios to keep in your back pocket:
Gross margin (gross profit divided by revenue) is a percentage that shows the amount of money the business has after accounting for the cost of goods sold. The higher the gross margin, the better. Net margin is an even better predictor of a business’s profitability, as it takes all expenses into account. To calculate it, divide your net income by your revenue.
Current ratio (current assets divided by current liabilities) is a ratio that is used to measure a company’s ability to pay their current obligations. This is also known as liquidity. If this ratio is above 1.00, this indicates that your company has enough cash to pay next month's bills. If the current ratio is below 1.00, this means there are more liabilities than assets, and your company probably doesn’t have enough cash on hand to pay your upcoming bills.
Debt-to-equity ratio (total liabilities dividend by shareholders’ equity) is used to evaluate the amount of financing a company has had. If you get a loan from a bank (CEBA for example), this would increase your total liabilities. Shareholders’ equity is the amount of funds that investors have placed in the business, plus all historical earnings of the company. If this ratio is high, it indicates that your company has borrowed a lot of money (and is not yet making more than you are borrowing).
6. Balance sheet
The balance sheet offers a snapshot of your overall financial position at a particular moment in time. It accounts for a company’s assets (such as cash, inventory, accounts receivable, and equipment), liabilities (like accounts payable, income tax, and employee salaries) and shareholders’ equity. In a nutshell, the balance sheet shows what you own, as well as what you owe.
7. Accounts payable and accounts receivable
Accounts payable come from the bills and invoices you need to pay for costs incurred to run your business, but haven’t been paid by the period end. So it's money you owe suppliers and any bills you have yet to pay. It’s listed as a liability on your balance sheet until the bills are paid.
Conversely, accounts receivable is money owed by your customers, but not yet paid. It is considered an asset on your balance sheet even though the revenue still needs to be collected.
However, beware of bad debt. This happens when you can’t collect payment from your customers. Outstanding accounts receivable are listed as an asset on your balance sheet, and must be written off as a bad debt expense as soon as you know you won’t collect on them. This removes the asset and increases the expense on your profit and loss statement.
8. Trial balance and general ledger
The trial balance is a summary of all the individual accounts that make up both your balance sheet and income statement (profit and loss statement). This shows the ending balance of each of these accounts at a specific date in time, which would typically be your year-end date.
The general ledger has the same accounts, except that it will show all the details for each individual transaction that went through each account, including the date that it happened.
Think of the trial balance as your “bank balance” and your general ledger as your “bank activity.”
Dividends are the payment of after-tax profit from your company to its shareholders. When a company makes profit during a year, this amount is added to the company’s retained earnings. Dividends reduce your retained earnings, and you can typically only pay out dividends until your retained earnings reaches zero. When you receive dividends as a shareholder, these have to be included on a personal income tax return through a T5 form.
10. Operating vs capital expenses
Operating expenses are things you spend money on to run your business. This would include things like cost of goods sold, administrative expenses, or research and development. Operating expenses are usually items that are used for one year or less, and cost under $1,000. These would show up as expenses on your income statement.
Capital expenses are recorded as assets on the balance sheet of the company. They’re typically used for more than one year. Capital assets are depreciated over their useful life, with a depreciation expense occurring on a regular basis (that’s included on the income statement). Examples would include computers, furniture or cars. Capital expenses are generally $1,000 and above.
Buying a vehicle would be a capital purchase, because you own it and can use the vehicle for many years. Leasing a vehicle would be an operating expense because you’re paying a monthly cost for the use of the vehicle, but your business doesn’t own it.
11. Fiscal year vs calendar year
A calendar period refers to the year ending on December 31, the calendar that we all follow during any given year.
A fiscal period refers to the 12 months that you select for your business. A Canadian corporation can select any year-end, and this day will be the base that decides when different deadlines for your business will be.
A business with a Sept. 30 fiscal year-end would have an operating year of Oct. 1, 2020 to Sept. 30, 2021. Personal taxes and sole proprietor taxes are always accounted for in a calendar year, and staggering the business fiscal year can open some interesting tax planning opportunities.
Small business accounting doesn’t have to be overwhelming; we’re here to help build your accounting knowledge and empower smarter decision-making with tips, tools and templates and educational webinars. Our team is here to help provide accounting, bookkeeping and tax services, and set you up for small business success.
Did you find this blog helpful? Read more about Small Business Basics topics that may be relevant to you and your small business.