Do you handle your own small business accounting?
Whether you handle your own accounting or have an accountant who takes care of your finances, there are lots of accounting concepts that you should understand. Why? To better grow and develop your business. Learning about accounting is not the most exciting, but it’s crucial to know the basics. This is to keep track of your small business income and expenses, which will ultimately increase your profit. Plus, you need detailed accounting records to file for your taxes.
So let’s take a look at what accounting is and why it’s important for small businesses.
What is small business accounting?
Small business accounting is basically measuring, processing and communicating financial information. It provides you (as the business owner) with information about your business’ resources, how to finance those resources and how to achieve good results. Accounting also involves a bookkeeper who prepares and interprets numbers to better determine the financial health of your business. In some small businesses, bookkeeping and accounting are outsourced to a private organization. But if you do decide to hire an accountant for your small business, be sure to do a background check on them to confirm their skills and qualifications.
As a first-time small business owner, you will most likely start reading or talking to others about accounting to broaden your knowledge. There are three main accounting terms that apply to how you should keep your records. It’s a good idea to familiarize yourself with these concepts. They are as follows:
- Chart of accounts – This is an organizational tool that lists all of your accounts. You can look at it as a major record-keeping system. The COA lists all the accounts that your business has made available for recording transactions in the general ledger. One important purpose of it is to classify assets, revenues, and liabilities so that anyone can easily get a better sense of your business’ financial health.
- Journals – Also called ‘journal entries’, this is where you enter your accounting transactions in order by date. There was a time where these transactions were manually posted to the accounts in the general ledger. Times have changed and these transactions occur automatically as soon as sales and vendor information are entered.
- General ledger – This is a ‘book’ that summarizes all of your business’ account transactions. The ledger is now commonly saved on software so there isn’t an actual physical book.
After putting all the ledger entries in your journals, you can turn that information into financial statements or reports. There are three financial main statements to consider:
- Income statements – This is a summary of the financial activities of your business during a specific accounting period (it can be a month, quarter or year). It shows your revenues and expenses. Revenues are sales you’ve made and expenses are everything that your business has spent money on.
- Balance sheet – It displays your business’ total assets and how they are financed; either through debt or equity. The balance sheet is based on this equation: Assets = Liabilities + Equity. Ultimately, these numbers need to balance each other out.
- Cash flow – It is the money that flows in and out of your business. The cash that comes in is from customers who are purchasing your products or services. If your customers don’t pay upfront, a portion of your cash flow will come from your account receivables. The cash that goes out of your small business is payments and expenses such as rent, mortgage, loan payments, taxes, and other account payables.
Accounting formulas to know
Besides tracking income and expenses or forecasting cash flow, accounting involves much more. There are a number of different tools you can use to set goals and assess your profits. Here are some of the most important accounting formulas that you should know:
This is also known as the balance sheet equation (as mentioned previously in the article). The formula adds liability with owner’s equity and the result should be your business’ assets. This is how it looks like:
Assets = Liabilities + Equity
This helps you compare your current assets to your liabilities. The formula for it is:
Current assets / Current liabilities = Current ratio
It is beneficial to know this formula because lenders look at the current ratio when offering funding. They usually want to see a 1.2 or higher ratio but of course, it all depends on your business industry. At the same time, if your ratio is less than 1, it means that you don’t have enough assets.
Variable Cost Ratio
This is mainly used by any business that sells goods. The variable cost ratio is the result of your total variable expenses divided by your net sales. Here is the formula:
Variable Costs / Net Sales = Variable Cost Ratio
Target Net Income
The formula for calculating net income is very simple:
Revenues – Expenses = Net income
But sometimes you might want to know your target net income. This is basically the target of how much you want to earn. You can definitely use the above formula to figure out ways to increase revenue and lower your expenses until your set target is met. But before doing so, it’s a good idea to break down your goal into units.
So the formula is as follows:
Sales – Variable Costs – Fixed Costs = Target Net Income
This is the total sales of your business minus the total cost of the goods sold. The formula is:
Revenue – Cost of Goods Sold (COGS) = Gross Profit
The COGS only takes into account the direct costs of producing goods. These include labour, materials, equipment for production and utilities in manufacturing facilities. It doesn’t take into account other taxes of costs.
This basically puts your gross profit (mentioned above) into a percentage and shows you which part of your revenue is actually profit. You can use this formula to calculate gross margin:
(Revenue – COGS)/ Revenue = Gross Profit Margin
It is the difference between the actual revenue and the budgeted revenue. Basically, it’s the difference between what you expected to profit from a sale and the actual amount that you profited because of a change in unit price. To calculate it, use this formula:
(Actual Cost Incurred – Standard Cost) x Actual Quantity = Price Variance
Accounting software(s) to help you out
There are many benefits to using accounting software for your small business. If you are a small business owner without employees, you can get by a basic online invoicing package like FreshBooks. It handles all of your invoicing, expense tracking and produces basic reports to keep track of your business.
But if you have employees and are incorporated, you will need more expansive accounting software like QuickBooks. They are specifically designed to do complex entries, such as Accounts Receivables, Account Payable & General Ledger.
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