Unless you are a finance or accounting professional, when starting a small business, you may not be fully conversant with all the various finance and accounting terms that you’ll come across, and what they mean in practice.
This is especially the case if you’ve never come across accounting terms before, and this is the first time you’ve set up a business.
Here are 12 fundamental accounting terms and what they mean.
1. Asset
An asset is anything of value your business owns, controls, or has a legal claim to; it could be a fixed asset, such as machinery or a resource, such as money in the bank. It can also be something that has economic value in the future. Assets can take many forms, both tangible (e.g., property) and intangible (e.g., copyrights and patents). Accounts receivable (see below) are classed as an asset.
2. Liability
A liability is anything your business owes to creditors in goods, services or money. For example, a business bank loan is a debt and therefore a liability. Accounts payable (see below) are classed as liabilities.
3. Cash flow
Cash flow is an accounting term for the money coming in and going out of your business at any given time. It’s especially important for small businesses and freelancers to have a healthy, positive cash flow so you have enough money to perform your tasks and pay your expenses (and yourself!). Even big companies with healthy profits on their balance sheet can experience difficulties if cash flow is tight. A cash flow statement is a key financial statement that tracks a company’s cash inflows and outflows.
4. Dividend
A dividend is an amount paid to company shareholders out of the company’s distributable profits. A dividend is a distribution of earnings, which is typically paid at regular intervals. The Board of Directors declares the timing and amount of dividends.
5. Accounts receivable
Accounts receivable are the amount of money due to your business for goods or services rendered. When you issue an invoice, this is classified as accounts receivable, i.e., money due to your business. It’s important to ensure your accounts receivable are up to date, as unpaid invoices can negatively impact your cash flow.
6. Accounts payable
Accounts payable is the opposite of accounts receivable and is the money owed to your creditors. It’s the amount your business owes for goods or services received and can include credit notes, subscriptions, unpaid bills, and outstanding debts.
7. Gross profit
Gross profit is the financial gain your business generates. It is calculated by total revenue from goods or services sold minus the direct cost of producing that revenue – the cost of goods sold (COGS), e.g., labor, raw materials, etc.
8. Net profit
Net profit is the financial gain your business generates after accounting for all expenses. So, just as with gross profit, you calculate total revenue and then deduct direct costs, COGS, and then you deduct operating expenses such as tax and interest.
9. Profit and loss statement
The profit and loss statement, also known as an income statement, shows your revenues, gains, expenses and losses over a set period. It’s a key financial statement that shows if your business is making a profit or a loss.
10. Balance sheet
A balance sheet is often referred to as a ‘snapshot’ of a business’s current financial position on a given date, typically year-end. It covers assets and liabilities and, if applicable, any shareholder equity. It’s a key financial statement that provides a high-level view of a company’s financial position.
11. Operating expenses
Operating expenses are the fixed and variable costs of running your day-to-day business. It can include rent, salaries and utilities as well as software, subscriptions and office supplies. It’s a good idea to keep tabs on these to ensure you’re not overpaying, could get a better deal elsewhere, or are subscribing to services you no longer use or need.
12. Return on investment
Return on investment (ROI) is the profit a business generates from a specific investment and is calculated by the profit divided by the original cost. You can then multiply by 100 to give you a percentage. It’s a handy metric for evaluating the profitability of your investment.
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Naturally, as well as being conversant with some of the most basic accounting terms, you’ll also need good tools to run your business and get paid quickly and on time.
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Note: The definitions here act as a guide only. For business accounting, auditing and financial advice, we highly recommend you seek expert professional guidance.
