When you start your own business, you wear a lot of hats. You’re the idea generator, the sales department, the cleanup crew, and often the accountant.
Yet many good small-business decisions rely on understanding some basic financial terms and accounting principles. Through these terms, you can gauge your business performance, communicate with potential investors, determine whether you’re making a profit, and plan for upcoming expenses, among other things.
According to the Small Business Administration, 78.6% of small businesses survived only one year between 2005 and 2017. These businesses may not have had the foundation needed to learn how their profits, expenses, accounting, and more affected their success. Understanding business financial terms may help you prevent that problem and have a thriving business for years to come.
If the idea of accounting terminology scares you, you’re not alone. If you get in over your head, it’s wise to hire a professional—but it’s still important to understand the basics.
These are the financial terms every small business owner should know.
Bookkeeping is the chronological documentation of transactions. As a business owner, you can track individual transactions by hand in a bookkeeping journal or a spreadsheet, or use software to automatically track transactions.
Business owners can use one of two processes for accounting: cash accounting or accrual accounting.
- Cash accounting: Common among those selling products. Income isn’t added up until you’ve actually received the check or cash, and expenses aren’t deducted until they’re paid.
- Accrual accounting: Counts income and expenses when they occur, not when they’re paid. This is most common among those providing and buying services or products requiring credit.
Also called a business ledger, this is where you chronologically track a day or week’s account balances. You should track the balances of accounts, credits, and debits, which are then used to get a big-picture view of your overall business.
These are anything your company owns that’s worth something. There are different ways to categorize business assets, but two basic categories are “current” and “fixed.”
- Current assets: These can be converted to cash within one year. Examples might include business accounts, stocks, and merchandise.
- Fixed assets: These are intended for long-term, repeated use without intent to sell, such as your office space or heavy machinery.
Income, revenue, and sales are all terms for the money that other people pay you for services or products, or investments others make in your business. If you extend credit to customers, they may owe money at a later date. A bill not yet paid by a customer falls into a category called accounts receivables, also known as AR or A/R.
Cost of Sales
These are variable expenses that usually go up as you increase sales. For example, the labor and materials involved in putting together a product for sale would be counted toward the cost of sales.
Gross Profit Margin
Gross profit margin is the amount you make before you subtract the cost of goods and services from your income. For example, if you bought a toy from a manufacturer for $2, and then sold the toy for $10, your gross profit margin would be $8.
Net Profit Margin
How much money does your business really make? Net profit margin reveals the answer after you’ve subtracted all expenses and costs. This could be labor or an ad you purchased on social media. For example, if it cost $3 to make a $10 toy after the cost of a $2 part for that toy, the net profit margin would be $5 ($10 - $3 - $2 = $5).
Expenses are fixed purchases you make for your business, such as a point-of-sale device, yoga mats, or insurance. If you make these purchases on credit, these expenses are known as accounts payable, also known as AP or A/P.
Every debt you are obligated to pay is considered a liability. Liabilities might include employee wages or money you owe to suppliers.
An expensive asset, such as a building or laptop, is a long-term investment in your business. However, some assets (like furniture and vehicles) lose value over time due to age, wear and tear, or because they’re no longer useful. Depreciation lowers the value of assets.
Most businesses don’t subtract the cost of the asset immediately. Instead, they spread it over many years, incorporating the item’s decreased value.
This is the share that you or your business partners own or have invested in your business, minus paid liabilities. This may also be called “capital,” and may include “capital investments” in the fixed assets for long-term use, such as the building you bought for your office.
At the end of an accounting period—such as at the end of the month or quarter—a business calculates the debits and credits as they stand currently in the general ledger. If you notice that the balance sheet doesn’t balance out, look for errors and adjustments.
This is a report of all your assets, liabilities, and equity at a particular point in time, after completing a trial balance. Your balance sheet may be important if you hope to sell your business in the future. It should show what your assets are after you add your liabilities and equity together.
This is also known as a profit and loss, or P&L, statement, which shows how much money you’ve made and how much you’ve spent during a specific range of time, such as a quarter or year. It’s an assessment of your profits and losses to determine your net profit over a quarter or fiscal year.
Cash Flow Statement
A cash flow statement is a real-time statement tracking how much cash you have coming in and from where (not credit), minus the cash you’re spending. Cash inflow is the sum of all money that has come in, from products or services you sell or have sold and are now paid for. The total cash outflow is the sum of any money you spent on your business, for example, buying inventory. Maintaining a healthy cash flow state may help you avoid bankruptcy.
The Bottom Line: Financial Terms and Your Business
While this may look complicated and intimidating at first, the more you understand about your finances, the better you’ll be at planning for your business’s future and making sound business decisions based on realistic calculations. A solid grasp of your business financial outlook can also help you pitch investors with confidence, be more prepared at tax time, and decide where to invest money in your business.