Every industry has its own special language, and accounting is no exception. Cost of goods sold, accrual basis accounting, cash flow: What do all these phrases really mean? What are the accounting concepts that are crucial to business operation?
You want to run a successful and profitable business, right? Of course you do, otherwise you wouldn’t be in business. In order to run a successful company, small business owners must be able to understand their true financial picture. To do this, you don’t need to be completely fluent in the language of accounting, but understanding the basic vocabulary and deeper concepts help. Below, we break down four accounting concepts that every small business owner needs to know with the “WHY IT MATTERS TO ME” following each concept.
Cost of Goods Sold vs. Expense
Cost of Goods Sold (COGS) are costs incurred as a direct result of selling a particular product or service. For example: Joe is a busy dentist. Items included in his cost of goods sold would be dental supplies that he uses in his office and that he provides to patients, hygiene-related supplies, costs associated with x-rays, lab expenses, and other costs related directly to providing care to patients.
Unlike COGS, expenses (often referred to as overhead expenses) are one-time or recurring costs not directly tied to a product or service. These are usually costs associated with doing business but not the direct result of a specific sale. In Joe’s case, his expenses could include rent, payroll, insurance costs, marketing, and other expenses related to keeping his dental practice open.
THE WHY: What does this do for my business?
Partitioning COGS from overhead expenses allows a business to determine if selling a particular product or service is profitable, especially compared to the company’s other offerings. Analyzing COGS can also help you pinpoint opportunities for managing and possibly reducing costs anywhere along the supply chain, potentially raising profitability for the company.
Accrual vs. Cash Basis Accounting
The term “accrual” can be applied to both sides of the ledger; in accounts receivable, they are sales completed but not yet billed, and in accounts payable, they are expenses incurred but not yet paid. In a nutshell, accruals are completed transactions that haven’t been settled up yet.
Companies using the accrual accounting method report earnings when they’re earned and expenses when they’re incurred – not when they’re paid. The expenses and earnings are reflected on the income statement for the period when the activity took place, not necessarily in the period when the money was sent or received.
Cash basis accounting, on the other hand, records expenses when they are paid and revenues when they are received. While this is a more straightforward method of accounting, it may not accurately reflect profitability for a specific period. For example, say you sell $10,000 of widgets in November, but you don’t receive payment for the sale until December. Under the accrual method, you will log the $10,000 in your November income statement, reflecting sales of $10,000 for that month. With the cash basis, you record the $10,000 as received in December – making it look as if November was much less profitable than it really was.
THE WHY: What does this do for my business?
There can be large tax implications depending on which method of accounting you decide to use for your business on a tax basis (it is best to walk through your options with a CPA to determine what is best for your tax situation). However, for bookkeeping purposes, almost all businesses should be tracking their books on accrual basis to get a true picture of performance.
Accrual accounting allows for the obvious necessity to track monies owed to the business for collection purposes and to track payables to know who you owe. Additionally, you are able to match these income and expense items within the same time period allowing you to really understand your overall income, costs and related profitability. This further allows for better future budgeting and goal setting as well as for projecting for future cash flow management.
Cash Flow
Money coming into and going out of your business is known as cash flow. Money flows in when customers or clients pay for your products or services and flows back out when you make payments incurred by your business. If more money is coming in then going out, you’re considered to have a “positive cash flow.” When the opposite is true, you have a “negative cash flow.”
There are many factors that come into play when managing cash flow, but the process can really be broken down to three fundamental questions. First, does your revenue cover your expenses? Second, are you collecting the receivables that are rightfully due to you on a timely basis? And third, are you managing your expenses so that you are only paying for what you need?
THE WHY: What does this do for my business?
Cash flow should always be a concern for startups as well as established businesses; in fact, the Small Business Administration lists “inadequate cash reserves” as a reason many companies don’t succeed.
Something to understand about cash flow is that it most likely does not mirror profitability as the timing of your collections and payables impact cash flow differently. For instance, your business may be profitable when you compare customer billings vs. expenses but you’re having trouble collecting funds timely so your cash is low (so you may not feel so profitable). Keeping track on the accrual basis helps you know that you are doing a good job pricing your work and keeping your costs under control and that what really needs work is your collections/payment policies. Projecting cash flow out a few months can also really help you plan for any bumps in the road before you hit them.
One way for businesses to protect themselves during times of negative cash flow is to have access to some form of working capital, usually in the form of a loan or line of credit.
For more about cash flow, read Cash Flow Management and Tools for your Business.
Budgeting
A budget is simply an estimate of revenue and expenses for a set period of time. The word “budget” often has a negative connotation, especially for visionary business owners who feel constrained by budget limits. Yet a business budget can give business owners a clearer idea of what to expect in the near future, both good and bad.
A small business can benefit from creating annual, quarterly and monthly budgets. Most accounting software, such as QuickBooks and Xero or a reporting software like Spotlight, include tools to not only input budget numbers but also run reports to show if your actual numbers are in-line with your budget – or if you need to make some adjustments.
THE WHY: What does this do for my business?
Similar to a budget for a household, a budget for your business can give a clear plan for the time period based on anticipated income and expenses. You may have a large piece of equipment you need to purchase before year end, or may need to stock up on supplies or inventory before the holidays if you’re a retailer, for example. There are many moving parts to a business and working with a CPA to create a budget can be a great tool to improve business operations.
Having a budget pushes you to strategically plan for your business. Your revenue goals included in the budget help you to plan for how you are going to achieve this goal, how many customers you need, and what marketing plan you need to implement to achieve this number of customers. This then rolls into how are you going to service these customers, what tools, software, people, supplies, etc. will be necessary and what financial as well as nonfinancial steps you need to take to achieve this.
It’s important for you as a business owner to have a basic understanding of common accounting terms and concepts, even if you have a dedicated team of accounting professionals minding the books. A better understanding of your company’s financial picture will improve communication with your accounting team, ultimately leading to more efficient decision-making and putting you firmly in the driver’s seat with the power to succeed.
To learn more terms in the accounting language, Intuit has put together 24 Accounting Terms Every Business Owner Needs to Know.
Summarizing Accounting Concepts for Business Owners
While you don’t have to be a professional accountant or earn your CPA license, if you own a business you need a working knowledge of some accounting concepts and terms to effectively manage and guide your business forward. We hope this list and the answers to the “Why?” questions you may have are helpful and give you a better working knowledge of these terms. If you are looking for more guidance and interested in having a free phone call with one of our virtual CFOs to discuss business growth further, please contact us today!
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