Are you new to the business world and find yourself Googling phrases like, “basic accounting for dummies” more often than you care to admit? Basic accounting can seem overwhelming–even if you have been doing business for a number of years, there are so many accounting-terms that it can be hard to remember them all. From time to time, you might think to yourself, what do people mean when they talk about cash flow or balance sheets, or, what on earth does “accrual accounting” refer to?
To refresh your accounting-knowledge, here are 11 basic accounting terms every business owner should know:
An asset refers to an item of value that your business owns. They can be physical—such as equipment and technology—or intangible, such as intellectual property.
When you owe a debt to somebody, it is known as a liability. Liabilities are your business’s financial obligations, such as salaries and wages you owe your employees, or purchases you have made but not yet paid for.
Equity refers to what you own in your business—investments, earnings, etc. While you might technically own the whole enterprise, equity is essentially the difference between your assets and liabilities. According to Fundera, the truth is that many businesses have negative equity because their owners might be taking out too much money or their ventures are not profitable. A formula to remember how to calculate equity is:
Equity = Assets – Liabilities
Cost of goods sold, also known as the cost of sales, is the cost of producing your products or delivering your services. It’s the first expense noted on your profit and loss statement and the first figure in calculating your gross profit margin.
Accounts receivable and accounts payable refer to money owed to you and money you owe, respectively.
Return on investment—commonly referred to as ROI—relates to the profit you make divided by the required investment to earn it. This number is usually a percentage, not a dollar amount, so if you have a total revenue of $10,000 and walk away with $6,000 after paying all expenses, your ROI is 150%.
Return on Investment = (Revenue – Investment Costs) / Investment Costs
Cash flow denotes the money entering and leaving your business. It’s like your venture’s lifeblood—money spent on payroll, operations, investments, etc. subtracted from money earned through sales and other functions for a particular period (usually a month). It is possible for this number to be negative for one or even several months and for your business to remain afloat—as long as immediately available funds (cash on hand) are sufficient.
Burn rate is similar to a business’s outflow of cash, however, burn rate usually implies a longer time interval. To calculate how fast you are spending money, subtract your cash on hand at the end of a given period (such as a fiscal quarter) from what you had at the beginning and divide it by the number of months. This basic accounting figure is essential for understanding how quickly your business goes through cash so that you can better manage your cash flow.
Difference = Starting Balance – Ending Balance
Cash Burn Rate = Difference / Number of Months
A balance sheet is a financial statement that documents your business’s assets, equity, and liabilities. It shows your business’s net worth. According to the Entrepreneur, a balance sheet is “a basic tenet of double-entry bookkeeping in that total assets (what a business owns) must equal liabilities plus equity (how the assets are financed). In other words, the balance sheet must balance.” It’s a simple equation, but it’s a vital part of making your business function successfully.
Assets = Liabilities + Equity
Another basic accounting practice to remember is maintaining a chart of accounts (COA). Your COA records all of your financial transactions, including what accounts you have open and with whom. While you should also be maintaining a general ledger, which is the foundation of your entire bookkeeping system from launch to present, your chart of accounts helps you make sense of it all.
Accrual accounting is a basic accounting method in which you record whether or not an exchange has occurred yet. So, if you make a deal with a client and they agree to pay you $1,000, you account for that $1,000 in your bookkeeping even if they have not paid you yet (likewise, you account for expenses even if you have not paid them). Why do this? It’s because this technique allows you to combine current cash inflows and outflows with expected cash inflows and outflows, which helps give you a more accurate picture of your financial condition.
Basic accounting does not have to be daunting, but it does require an understanding of a variety of interrelated terms. There are a lot of other terms out there, but having a firm grasp of the most basic ones will help you manage your business effectively.