From Daniel Richards
How to use financial statements as a management tool, Part 3
The following is the third in a series of three articles on using financial statements as a management tool. The series references the 2006 annual report from Target Corp. from the retailer's web site.
A cash flow statement, along with the balance sheet and income statement, are the three most common financial statements used to gauge a company’s performance and overall health. The same accounting data is used in preparing all three statements, but each takes a company’s pulse in a different area.
The cash flow statement discloses how a company raised money and how it spent those funds during a given period. It is also an analytical tool, measuring an enterprise’s ability to cover its expenses in the near term. Generally speaking, if a company is consistently bringing in more cash than it spends, that company is considered to be of good value.
A cash flow statement is divided into three parts: operations, investing and financing. The following is an analysis of a real-world cash flow statement belonging to Target Corp. Note that all figures represent millions of dollars.
Cash from operations: This is cash that was generated over the year from the company’s core business transactions. Note how the statement starts with net earnings and works backward, adding in depreciation and subtracting out inventory and accounts receivable. In simple terms, this is earnings before interest and taxes (EBIT) plus depreciation minus taxes.
Interpretation:This may serve as a better indicator than earnings, since noncash earnings can’t be used to pay off bills.
Cash from investing: Some businesses will invest outside their core operations or acquire new companies to expand their reach.
Interpretation: This portion of the cash flow statement accounts for cash used to make new investments, as well as proceeds gained from previous investments. In Target’s case, this number in 2006 was -4,693, which shows the company spent significant cash investing in projects it hopes will lead to future growth.
Cash from financing: This last section refers to the movement of cash from financing activities. Two common financing activities are taking on a loan or issuing stock to new investors.
Dividends to current investors also fit in here. Again, Target reports a negative number for 2006, -1,004. But this should not be misconstrued: The company paid off 1,155 of its previous debt, paid out 380 in dividends and repurchased 901 of company stock.
Interpretation: Investors will like these last two items, since they reap the dividends, and it signals that Target is confident in its stock performance and wants to keep it for the company’s gain. A simple formula for this section: cash from issuing stock minus dividends paid, minus cash used to acquire stock.
The final step in analyzing cash flow is to add the cash balances from the reporting year (2006) and the previous year (2005); in Target’s case that’s -835 plus 1,648, which equals 813. Even though Target ran a negative cash balance in both years, it still has an overall positive cash balance due to its high cash surplus in 2004.
Wednesday, June 25, 2008
Interpreting the Income Statement
From Daniel Richards
How to use financial statements as a management tool, Part 2
The following is the first in a series of three articles on using financial statements as a management tool. The series references the 2006 annual report from Target Corp. from the retailer's web site.
Like a balance statement, an income statement is a means for measuring a company’s financial performance. Some of the ratios discussed draw data from both the income statement and the balance sheet.
We’ll continue using the published data from Target as an example. Note that all figures represent millions of dollars.
Gross profit margin: The money Target earns from selling a T-shirt, minus what it paid for that item -- known as cost of goods sold, or COGS -- is called gross profit. Sales minus COGS, divided by sales, yields the gross profit margin. According to Target’s income statement, that would be 59,490 minus 39,399, divided by 59,490, which equals 0.337, or 33.7 percent.
Operating income: This is gross profit minus operating expenses minus depreciation. It is also called EBIT (earnings before interest and taxes). Using Target’s data, the formula would be expressed as: 59,490 minus 39,399 minus 12,819 minus 707 minus 1,496, which equals 5,069.
Operating profit margin: Use the total derived in the previous step and divide it by total sales. In this case the equation is 5,069 divided by 59,490, which equals .085, or 8.5 percent.
Interpretation: This tally is also known as EBIT margin and is an effective way to measure operational efficiency. If you find this number to be low, either raise revenues or cut costs. It may help to analyze which of your customers are the most profitable and concentrate your efforts there.
Net profit margin: Net earnings divided by total revenue yields the net profit margin. In this case, 2,787 divided by 59,490, which equals .047, or 4.7 percent.
ROA: This stands for return on assets and measures how much profit a company is generating for each dollar of assets. Calculate ROA by dividing the revenue figure from the income statement by assets from the balance sheet. For Target, that equates to 59,490 divided by 14,706, which equals 4.04. In other words, for every dollar Target has in assets, it is able to generate $4.04 of revenue.
ROE: The same idea as above, but replacing assets with the equity. In this case, 59,490 divided by 15,633, which equals 3.81.
Accounts receivable collection: Many businesses experience a lag between the time they bill customers and when they see the revenue. This may be due to trade credit or because customers are not paying. While you can note this potential revenue in the balance sheet under accounts receivable, if you’re not able to collect it, eventually your business will lack sufficient cash.
Interpretation: To measure how many days it takes to collect all accounts receivable, use this formula: 365 (days) divided by accounts receivable turnover (total net sales divided by accounts receivable). In Target’s case, that equates to 365 divided by the sum of 59,490 divided by 6,194, which equals 38. This means that, on average, it takes Target 38 days to collect on its accounts. If you find your business has a healthy balance sheet but is short on cash, increase collection on outstanding accounts.
How to use financial statements as a management tool, Part 2
The following is the first in a series of three articles on using financial statements as a management tool. The series references the 2006 annual report from Target Corp. from the retailer's web site.
Like a balance statement, an income statement is a means for measuring a company’s financial performance. Some of the ratios discussed draw data from both the income statement and the balance sheet.
We’ll continue using the published data from Target as an example. Note that all figures represent millions of dollars.
Gross profit margin: The money Target earns from selling a T-shirt, minus what it paid for that item -- known as cost of goods sold, or COGS -- is called gross profit. Sales minus COGS, divided by sales, yields the gross profit margin. According to Target’s income statement, that would be 59,490 minus 39,399, divided by 59,490, which equals 0.337, or 33.7 percent.
Operating income: This is gross profit minus operating expenses minus depreciation. It is also called EBIT (earnings before interest and taxes). Using Target’s data, the formula would be expressed as: 59,490 minus 39,399 minus 12,819 minus 707 minus 1,496, which equals 5,069.
Operating profit margin: Use the total derived in the previous step and divide it by total sales. In this case the equation is 5,069 divided by 59,490, which equals .085, or 8.5 percent.
Interpretation: This tally is also known as EBIT margin and is an effective way to measure operational efficiency. If you find this number to be low, either raise revenues or cut costs. It may help to analyze which of your customers are the most profitable and concentrate your efforts there.
Net profit margin: Net earnings divided by total revenue yields the net profit margin. In this case, 2,787 divided by 59,490, which equals .047, or 4.7 percent.
ROA: This stands for return on assets and measures how much profit a company is generating for each dollar of assets. Calculate ROA by dividing the revenue figure from the income statement by assets from the balance sheet. For Target, that equates to 59,490 divided by 14,706, which equals 4.04. In other words, for every dollar Target has in assets, it is able to generate $4.04 of revenue.
ROE: The same idea as above, but replacing assets with the equity. In this case, 59,490 divided by 15,633, which equals 3.81.
Accounts receivable collection: Many businesses experience a lag between the time they bill customers and when they see the revenue. This may be due to trade credit or because customers are not paying. While you can note this potential revenue in the balance sheet under accounts receivable, if you’re not able to collect it, eventually your business will lack sufficient cash.
Interpretation: To measure how many days it takes to collect all accounts receivable, use this formula: 365 (days) divided by accounts receivable turnover (total net sales divided by accounts receivable). In Target’s case, that equates to 365 divided by the sum of 59,490 divided by 6,194, which equals 38. This means that, on average, it takes Target 38 days to collect on its accounts. If you find your business has a healthy balance sheet but is short on cash, increase collection on outstanding accounts.
Interpreting the Balance Sheet
From Daniel Richards
How to use financial statements as a management tool, Part 1
The following is the first in a series of three articles on using financial statements as a management tool. The series references the 2006 annual report from Target Corp. from the retailer's web site. The financial statements begin on document p. 24 (p. 43 of the PDF file).
The information provided here allows you to calculate several financial ratios that measure company performance. Additionally, current balance sheets should always present data from at least one previous period, so you can compare how financial performance has changed.
Identify a public company in the same industry as your startup and download their financial statements from their Web site. Using Target Corp. as an example, we’ll analyze the data in their balance sheet. Here are a few key ratios to calculate. Note that all figures represent millions of dollars.
Quick ratio: This measures Target’s ability to meet its obligations without selling off inventory; the higher the result, the better. It is expressed as current assets minus inventories, divided by current liabilities. In Target’s case, that is 14,706 minus 6,254, divided by 11,117, which equals 0.76.
Interpretation: If this number declines over time or falls short of your benchmark, you may be investing too much capital in inventory or you may have taken on too much short-term debt.
Current ratio: This is another test of short-term liquidity, determined by dividing current assets by current liabilities. In Target’s case, that is equivalent to 14,706 divided by 11,117, which equals 1.32.
Interpretation: This number should be above 1, and it’s usually a sign of strength if it exceeds 2. If this number is below 1, that means your short-term liabilities exceed your short-term assets. A liability is considered current if it is due within a year. An asset is current if it can be converted into cash within a year.
Debt-to-equity ratio: In brief, divide total debt by total equity. In Target’s case, the denominator is termed a shareholder’s investment because Target is a public company. Using Target’s data, that ratio is expressed as 8,675 divided by 15,633, which equals 0.555.
Interpretation: Long-term creditors will view this number as a measure of how aggressive your firm is. If your business is already levered up with debt, they may be reluctant to offer additional financing.
Working capital: This refers to the cash available for daily operations. It is derived by subtracting current liabilities from current assets, which in this example is 14,706 minus 11,117, which equals 3,589.
Interpretation: If this number is negative, that means your firm is unable to meet its current obligations. To improve this number, examine your inventory management practices; a backup of goods and the resulting loss in sales can take a toll on your business’s cash resources.
©2007 About.com, Inc., a part of The New York Times Company. All rights reserved.
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Tuesday, June 24, 2008
When to hire a bookkeeper
These points should help businesspeople looking to hire a bookkeeper.
When to Hire a Bookkeeper:
Company Start-up: A bookkeeper's services make sense for average start-ups with no plans on building an empire. A bookkeeper on your small business accounting team will help you start off with a good record keeping system, handle financial transactions, and produce financial statements.
Lack of Numbers Understanding: If cash flow planning and balance sheets make your head spin, you need help. Enlisting the services of a bookkeeper can help you gain a basic understanding of the financial aspects of running a business.
One-Person Company: A home-based lifestyle business will have a need to keep expenses low. The cost of an accountant on a monthly basis can be too much for a small one-person business. Either prepare the books yourself or have a bookkeeper involved in the process. Use the accountant for your year-end tax planning.
When to Hire a Bookkeeper:
Company Start-up: A bookkeeper's services make sense for average start-ups with no plans on building an empire. A bookkeeper on your small business accounting team will help you start off with a good record keeping system, handle financial transactions, and produce financial statements.
Lack of Numbers Understanding: If cash flow planning and balance sheets make your head spin, you need help. Enlisting the services of a bookkeeper can help you gain a basic understanding of the financial aspects of running a business.
One-Person Company: A home-based lifestyle business will have a need to keep expenses low. The cost of an accountant on a monthly basis can be too much for a small one-person business. Either prepare the books yourself or have a bookkeeper involved in the process. Use the accountant for your year-end tax planning.
Tuesday, June 17, 2008
I found this article on putting more cash at your disposal
This is an excellent article for my clients to read.
Guide to Filling a Cash Flow Shortage
How to put more ready cash at your disposalBy Daniel Kehrer
SupremelyUseful
9.6
out of 10
Choose your rating
9.6 - Supremely Useful
Bringing cash in the door is one of the most basic requirements of operating a successful business and cash shortfall is as common as the common cold. But don't get caught up in fancy cash predicting formulas. The basics of cash flow are common sense.
Translate sales into real money (cash) as fast as possible
Bank that money
Guard that cash zealously.Action StepsThe best contacts and resources to help you get it done
Use online invoicing or invoicing softwareA messy, unclear or inaccurate invoice is far less likely to be paid on time, if at all. Make sure what you send out reflects care and attention to detail. I recommend: Inexpensive, easy-to-use invoicing software can help pull in more cash. MyInvoices is an excellent choice. Web-based invoicing services are also a great solution that has come on strong in recent years. FreshBooks and Bill.com are both terrific places to send, track and collect payments quickly. FreshBooks has been especially popular with freelancers and service providers. Not only to you save time billing, but you get paid faster.
Sign up for a merchant accountMerchant accounts allow you to take payments by credit cards. For speedier cash flow, credit cards can't be beat. You get your money fast and customers are accustomed to paying with plastic. I recommend: Visa, MasterCard and American Express all have super helpful small business sites that can get you set up to accept credit cards. You might also consider PayPal if you are an internet business.
Use Remote Check DepositRemote check deposit lets you easily convert paper checks to electronic checks and have the money magically deposited into your business bank account via your computer. I recommend: Plus, the now-electronic checks can launch your accounting software and automatically enter the check deposits and update your ledgers. Wow! The tools for creating electronic checks, or echecks, from regular paper checks are being offered by banks and Web-based providers. Using a special desktop scanner, you convert checks to digital images, and then deposit them to your bank account via the Internet. The efficiency is jaw dropping. DepositNow is a complete Web-based service that can set you up to use remote check deposit to your existing bank. See why it's like having a tiny ATM on your desk, and how the additional accounts receivable service can automatically enter information to help balance your books. The National ACH network is another provider of remote check deposit services.
Crank up your collectionsIf you aren't having any luck collecting from clients, call in the collections cavalry. Get a collection agency specialist to help you out. I recommend: Find one at The Association of Credit & Collection Professionals.
Get a line of credit with a bankTap the credit line to cover short term cash shortfalls. I recommend: Wells Fargo, Washington Mutual and Bank of America are three major banks that cater to small business and offer credit lines nationwide. Or check out the SBA CAPlines Loan Program which helps small businesses meet short-term and seasonal cash needs with a revolving line of credit.
Create a cash-in/cash-out budget. This will allow you to estimate your cash in and cash out over a six-month period. I recommend: Go here to download a cash flow budget worksheet template that will get it done.
Tips & Tactics Helpful advice for making the most of this Guide
Try asking for all or a portion of payment up front.
Create a detailed "aging schedule" for your receivables. Call overdue accounts quickly, focusing on the largest amounts first.
Offer a discount for overdue amounts, but only after you've pressed for full payment. Set a short deadline and make it sweet enough to draw a response.
Prepare invoices in advance and send them out at the earliest possible moment
Guide to Filling a Cash Flow Shortage
How to put more ready cash at your disposalBy Daniel Kehrer
SupremelyUseful
9.6
out of 10
Choose your rating
9.6 - Supremely Useful
Bringing cash in the door is one of the most basic requirements of operating a successful business and cash shortfall is as common as the common cold. But don't get caught up in fancy cash predicting formulas. The basics of cash flow are common sense.
Translate sales into real money (cash) as fast as possible
Bank that money
Guard that cash zealously.Action StepsThe best contacts and resources to help you get it done
Use online invoicing or invoicing softwareA messy, unclear or inaccurate invoice is far less likely to be paid on time, if at all. Make sure what you send out reflects care and attention to detail. I recommend: Inexpensive, easy-to-use invoicing software can help pull in more cash. MyInvoices is an excellent choice. Web-based invoicing services are also a great solution that has come on strong in recent years. FreshBooks and Bill.com are both terrific places to send, track and collect payments quickly. FreshBooks has been especially popular with freelancers and service providers. Not only to you save time billing, but you get paid faster.
Sign up for a merchant accountMerchant accounts allow you to take payments by credit cards. For speedier cash flow, credit cards can't be beat. You get your money fast and customers are accustomed to paying with plastic. I recommend: Visa, MasterCard and American Express all have super helpful small business sites that can get you set up to accept credit cards. You might also consider PayPal if you are an internet business.
Use Remote Check DepositRemote check deposit lets you easily convert paper checks to electronic checks and have the money magically deposited into your business bank account via your computer. I recommend: Plus, the now-electronic checks can launch your accounting software and automatically enter the check deposits and update your ledgers. Wow! The tools for creating electronic checks, or echecks, from regular paper checks are being offered by banks and Web-based providers. Using a special desktop scanner, you convert checks to digital images, and then deposit them to your bank account via the Internet. The efficiency is jaw dropping. DepositNow is a complete Web-based service that can set you up to use remote check deposit to your existing bank. See why it's like having a tiny ATM on your desk, and how the additional accounts receivable service can automatically enter information to help balance your books. The National ACH network is another provider of remote check deposit services.
Crank up your collectionsIf you aren't having any luck collecting from clients, call in the collections cavalry. Get a collection agency specialist to help you out. I recommend: Find one at The Association of Credit & Collection Professionals.
Get a line of credit with a bankTap the credit line to cover short term cash shortfalls. I recommend: Wells Fargo, Washington Mutual and Bank of America are three major banks that cater to small business and offer credit lines nationwide. Or check out the SBA CAPlines Loan Program which helps small businesses meet short-term and seasonal cash needs with a revolving line of credit.
Create a cash-in/cash-out budget. This will allow you to estimate your cash in and cash out over a six-month period. I recommend: Go here to download a cash flow budget worksheet template that will get it done.
Tips & Tactics Helpful advice for making the most of this Guide
Try asking for all or a portion of payment up front.
Create a detailed "aging schedule" for your receivables. Call overdue accounts quickly, focusing on the largest amounts first.
Offer a discount for overdue amounts, but only after you've pressed for full payment. Set a short deadline and make it sweet enough to draw a response.
Prepare invoices in advance and send them out at the earliest possible moment
Saturday, June 14, 2008
Bookkeeping 101
This primer on basic accounting terms and principles should help my clients understand what
I do for them and how a good bookkeeping system can help grow their businesses.
Accounting Basics
If you understand the definition and goals of an accounting system, you are ready to learn the following accounting concepts and definitions.
Assets: Things of value held by the business. Assets are balance sheet accounts. Examples of assets are cash, accounts receivable, and furniture and fixtures.
Liabilities: What your business owes creditors. Liabilities are balance sheet accounts. Examples are accounts payable, payroll taxes payable, and loans payable.
Equity: The net worth of your company. Also called owner's equity or capital. Equity comes from investment in the business by the owners, plus accumulated net profits of the business that have not been paid out to the owners. It essentially represents amounts owed to the owners. Equity accounts are balance sheet accounts.
The accounting equation: Assets = liabilities + owner's equity. The financial statement called the balance sheet is based on the "accounting equation." Note that assets are on the left-hand side of the equation, and liabilities and equities are on the right-hand side of the equation. Similarly, some balance sheets are presented so that assets are on the left, liabilities and owner's equity are on the right.
Balance sheet: Also called a statement of financial position, a balance sheet is a financial "snapshot" of your business at a given date in time. It lists your assets, your liabilities, and the difference between the two, which is your equity, or net worth. The balance sheet is a real-life example of the accounting equation because it shows that assets = liabilities + owner's equity.
Once you master the above accounting terms and concepts, you are ready to learn about the following day-to-day accounting terms.
Debits: At least one component of every accounting transaction (journal entry) is a debit amount. Debits increase assets and decrease liabilities and equity. For this reason, you will sometimes see debits entered on the left-hand side (the asset side of the accounting equation) of a two-column journal or ledger.
Credits: At least one component of every accounting transaction (journal entry) is a credit amount. Credits increase liabilities and equity and decrease assets. For this reason, you will sometimes see credits entered on the right-hand side (the liability and equity side of the accounting equation) of a two-column journal or ledger.
In bookkeeping texts, examples, and ledgers, you may see the words "Debit" and "Credit" abbreviated. Dr. stands for Debit; Cr. Stands for Credit.
Double-entry accounting: In double-entry accounting, every transaction has two journal entries: a debit and a credit. Debits must always equal credits. Because debits equal credits, double-entry accounting prevents some common bookkeeping errors. Errors that do occur are easier to find. Double
Definitions of Accounting Terms
The following terms are often used by accountants, in accounting software, and in fact throughout our discussion. We've placed their definitions here so that you can print them out, if you want. Definitions are also scattered throughout the text — when you see blue or gray underlined text, click on the word to get more information.
Accounting equation: Assets = liabilities + owner's equity. The accounting equation is the basis for the financial statement called the balance sheet.
Accounts payable: Also called A/P, accounts payable are the bills your business owes to suppliers.
Accounts receivable: Also called A/R, accounts receivable are the amounts owed to you by your customers.
Accrual method of accounting: With the accrual method, you record income when the sale occurs, not necessarily when you receive payment. You record an expense when you receive goods or services, even though you may not pay for them until later.
Adjusting entries: Special accounting entries that must be made when you close the books at the end of an accounting period. Adjusting entries are necessary to update your accounts for items that are not recorded in your daily transactions.
Aging report: An aging report is a list of customers' accounts receivable amounts and their due dates. It alerts you to any slow-paying customers. You can also prepare an aging report for your accounts payable, which will help you manage your outstanding bills.
Allowance for bad debts: Also called reserve for bad debts, it is an estimate of uncollectable customer accounts. It is known as a "contra" account because it is listed with the assets, but it will have a credit balance instead of a debit balance. For balance sheet purposes, it is a reduction of accounts receivable.
Assets: Things of value held by the business. Assets are balance sheet accounts. Examples of assets are cash, accounts receivable, and furniture and fixtures.
Balance sheet: Also called a statement of financial position, it is a financial "snapshot" of your business at a given date in time. It lists your assets, your liabilities, and the difference between the two, which is your equity, or net worth.
Capital: Money invested in the business by the owners. Also called equity.
Cash method of accounting: If you use the cash method, you record income only when you receive cash from your customers. You record an expense only when you write the check to the vendor.
Chart of accounts: The list of account titles you use to keep your accounting records.
Closing: Closing the books refers to procedures that take place at the end of an accounting period. Adjusting entries are made, and then the income and expense accounts are "closed." The net profit that results from the closing of the income and expense accounts is transferred to an equity account such as retained earnings.
Corporation: A legal entity, formed by the issuance of a charter from the state. A corporation is owned by one or more stockholders.
Cost of goods sold: Cost of inventory items sold to your customers. It may consist of several cost components, such as merchandise purchase costs, freight, and manufacturing costs.
Credit memo: Writing off all or part of a customer's account balance. A credit memo would be required, for example, when a customer who bought merchandise on account returned some merchandise, or overpaid on their account.
Credits: At least one component of every accounting transaction (journal entry) is a credit. Credits increase liabilities and equity and decrease assets.
Current assets: Assets that are in the form of cash or will generally be converted to cash or used up within one year. Examples are accounts receivable and inventory.
Current liabilities: Liabilities payable within one year. Examples are accounts payable and payroll taxes payable.
Debit memo: Billing a customer again. A debit memo would be required, for example, when a customer has made a payment on their account by check, but the check bounced.
Debits: At least one component of every accounting transaction (journal entry) is a debit. Debits increase assets and decrease liabilities and equity.
Depreciation: An annual write-off of a portion of the cost of fixed assets, such as vehicles and equipment. Depreciation is listed among the expenses on the income statement.
Double-entry accounting: In double-entry accounting, every transaction has two journal entries: a debit and a credit. Debits must always equal credits. Double-entry accounting is the basis of a true accounting system.
Drawing account: A general ledger account used by some sole proprietorships and partnerships to keep track of amounts drawn out of the business by an owner.
Equity: The net worth of your company. Also called owner's equity or capital. Equity comes from investment in the business by the owners, plus accumulated net profits of the business that have not been paid out to the owners. Equity accounts are balance sheet accounts.
Expense accounts: These are the accounts you use to keep track of the costs of doing business: where your money goes. Examples are advertising, payroll taxes, and wages. Expenses are income statement accounts.
Fixed assets: Assets that are generally not converted to cash within one year. Examples are equipment and vehicles.
Foot: To total the amounts in a column, such as a column in a journal or a ledger.
General ledger: A general ledger is the collection of all balance sheet, income, and expense accounts used to keep the accounting records of a business.
Income accounts: These are the accounts you use to keep track of your sources of income. Examples are merchandise sales, consulting revenue, and interest income.
Income statement: Also called a profit and loss statement or a "P&L." It lists your income, expenses, and net profit (or loss). The net profit (or loss) is equal to your income minus your expenses.
Inventory: Goods you hold for sale to customers. Inventory can be merchandise you buy for resale, or it can be merchandise you manufacture or process, selling the end product to the customer.
Journal: The chronological, day-to-day transactions of a business are recorded in sales, cash receipts, and cash disbursements journals. A general journal is used to enter period end adjusting and closing entries and other special transactions not entered in the other journals. In a traditional, manual accounting system, each of these journals is a collection of multi-column spreadsheets usually contained in a hardcover binder.
Liabilities: What your business owes creditors. Liabilities are balance sheet accounts. Examples are accounts payable, payroll taxes payable, and loans payable.
Long-term liabilities: Liabilities that are not due within one year. An example would be a mortgage payable.
Merchandise inventory: Goods held for sale to customers.
Net income: Also called profit or net profit, it is equal to income minus expenses. Net income is the bottom line of the income statement (also called the profit and loss statement).
Partnership: An unincorporated business with two or more owners.
Post: To summarize all journal entries and transfer them to the general ledger accounts. This is done at the end of an accounting period.
Prepaid expenses: Amounts you have paid in advance to a vendor or creditor for goods or services. A prepaid expense is actually an asset of your business because your vendor or supplier owes you the goods or services. An example would be the unexpired portion of an annual insurance premium.
Prepaid income: Also called unearned revenue, it represents money you have received in advance of providing a service to your customer. Prepaid income is actually a liability of your business because you still owe the service to the customer. An example would be an advance payment to you for some consulting services you will be performing in the future.
Profit and loss statement: Also called an income statement or "P&L." It lists your income, expenses, and net profit (or loss). The net profit (or loss) is equal to your income minus your expenses.
Proprietorship: An unincorporated business with only one owner.
Reserve for bad debts: Also called allowance for bad debts, it is an estimate of uncollectable customer accounts. It is known as a "contra" account because it is listed with the assets, but it will have a credit balance instead of a debit balance. For balance sheet purposes, it is a reduction of accounts receivable.
Retained earnings: Profits of the business that have not been paid to the owners; profits that have been "retained" in the business. Retained earnings is an "equity" account that is presented on the balance sheet and on the statement of changes in owners' equity.
Sole proprietorship: An unincorporated business with only one owner.
Trial balance: A trial balance is prepared at the end of an accounting period by adding up all the account balances in your general ledger. The debit balances should equal the credit balances.
Unearned revenue: Also called prepaid income, it represents money you have received in advance of providing a service to your customer. It is actually a liability of your business because you still owe the service to the customer. An example would be an advance payment to you for some consulting services you will be performing in the future.
Cash vs. Accrual Accounting
There are two basic accounting methods available to most small businesses: cash or accrual.
Cash method. If you use the cash method of accounting, you record income only when you receive cash from your customers. You record an expense only when you write the check to the vendor. Most individuals use the cash method for their personal finances because it's simpler and less time-consuming. However, this method can distort your income and expenses, especially if you extend credit to your customers, if you buy on credit from your suppliers, or you keep an inventory of the products you sell.
Accrual method. With the accrual method, you record income when the sale occurs, whether it be the delivery of a product or the rendering of a service on your part, regardless of when you get paid. You record an expense when you receive goods or services, even though you may not pay for them until later. The accrual method gives you a more accurate picture of your financial situation than the cash method. This is because you record income on the books when it is truly earned, and you record expenses when they are incurred. Income earned in one period is accurately matched against the expenses that correspond to that period, so you get a better picture of your net profits for each period.
Pros and cons. The cash method is easier to maintain because you don't record income until you receive the cash, and you don't record an expense until the cash is paid. With the accrual method, you will typically record more transactions. For example, if you make a sale on account (or, on credit), you would record the transaction at the time of the sale, with an entry to the receivables account. Then, when the customer pays their bill, you will record the receipt on account as another transaction. With the cash method, the only transaction that is recorded is when the customer pays the bill. If you are using computer software to do your accounting, this is probably not a big concern, since the computer program automates much of the extra effort required by the accrual method.
Another issue to be considered is the accounting method you use for tax purposes. For convenience, you probably want to use the same method for your internal reporting that you use for tax purposes. However, the IRS permits you to use a different method for tax purposes. Some businesses can use the cash method for tax purposes. If you maintain an inventory, you will have to use the accrual method, at least for sales and purchases of inventory for resale.
We recommend the accrual method for all businesses, even if the IRS permits the cash method, because accrual gives you a clearer picture of the financial status of your business. You probably need to keep a record of accounts receivable and accounts payable anyway, so you are already keeping track of all the information needed to do your books on the accrual basis. If you are using a computer program, there really isn't much extra effort involved in using the accrual
-entry accounting is the basis of a true accounting system.
In double-entry accounting, every transaction in your business affects at least two accounts, since there is at least one debit and one credit for each transaction. Usually, at least one of the accounts is a balance sheet account. Entries that are not made to a balance sheet account are made to an income or expense account. Income and expenses affect the net profit of the business, which ultimately affects owner's equity. Each transaction (journal entry) is a real-life example of the accounting equation (assets = liabilities + owner's equity).
Some simple accounting systems do not use the double-entry system. You will have to choose between double-entry and single-entry accounting. Because of the benefits described above, we recommend double-entry accounting. Many accounting programs for the computer are based on a double-entry system, but are designed so that you enter each transaction once, and the computer makes the corresponding second entry for you. The double-entry part goes on "behind the scenes," so to speak.
You also need to decide whether you will be using the cash or accrual accounting method. We recommend the accrual method because it provides a more accurate picture of your financial situation.
I do for them and how a good bookkeeping system can help grow their businesses.
Accounting Basics
If you understand the definition and goals of an accounting system, you are ready to learn the following accounting concepts and definitions.
Assets: Things of value held by the business. Assets are balance sheet accounts. Examples of assets are cash, accounts receivable, and furniture and fixtures.
Liabilities: What your business owes creditors. Liabilities are balance sheet accounts. Examples are accounts payable, payroll taxes payable, and loans payable.
Equity: The net worth of your company. Also called owner's equity or capital. Equity comes from investment in the business by the owners, plus accumulated net profits of the business that have not been paid out to the owners. It essentially represents amounts owed to the owners. Equity accounts are balance sheet accounts.
The accounting equation: Assets = liabilities + owner's equity. The financial statement called the balance sheet is based on the "accounting equation." Note that assets are on the left-hand side of the equation, and liabilities and equities are on the right-hand side of the equation. Similarly, some balance sheets are presented so that assets are on the left, liabilities and owner's equity are on the right.
Balance sheet: Also called a statement of financial position, a balance sheet is a financial "snapshot" of your business at a given date in time. It lists your assets, your liabilities, and the difference between the two, which is your equity, or net worth. The balance sheet is a real-life example of the accounting equation because it shows that assets = liabilities + owner's equity.
Once you master the above accounting terms and concepts, you are ready to learn about the following day-to-day accounting terms.
Debits: At least one component of every accounting transaction (journal entry) is a debit amount. Debits increase assets and decrease liabilities and equity. For this reason, you will sometimes see debits entered on the left-hand side (the asset side of the accounting equation) of a two-column journal or ledger.
Credits: At least one component of every accounting transaction (journal entry) is a credit amount. Credits increase liabilities and equity and decrease assets. For this reason, you will sometimes see credits entered on the right-hand side (the liability and equity side of the accounting equation) of a two-column journal or ledger.
In bookkeeping texts, examples, and ledgers, you may see the words "Debit" and "Credit" abbreviated. Dr. stands for Debit; Cr. Stands for Credit.
Double-entry accounting: In double-entry accounting, every transaction has two journal entries: a debit and a credit. Debits must always equal credits. Because debits equal credits, double-entry accounting prevents some common bookkeeping errors. Errors that do occur are easier to find. Double
Definitions of Accounting Terms
The following terms are often used by accountants, in accounting software, and in fact throughout our discussion. We've placed their definitions here so that you can print them out, if you want. Definitions are also scattered throughout the text — when you see blue or gray underlined text, click on the word to get more information.
Accounting equation: Assets = liabilities + owner's equity. The accounting equation is the basis for the financial statement called the balance sheet.
Accounts payable: Also called A/P, accounts payable are the bills your business owes to suppliers.
Accounts receivable: Also called A/R, accounts receivable are the amounts owed to you by your customers.
Accrual method of accounting: With the accrual method, you record income when the sale occurs, not necessarily when you receive payment. You record an expense when you receive goods or services, even though you may not pay for them until later.
Adjusting entries: Special accounting entries that must be made when you close the books at the end of an accounting period. Adjusting entries are necessary to update your accounts for items that are not recorded in your daily transactions.
Aging report: An aging report is a list of customers' accounts receivable amounts and their due dates. It alerts you to any slow-paying customers. You can also prepare an aging report for your accounts payable, which will help you manage your outstanding bills.
Allowance for bad debts: Also called reserve for bad debts, it is an estimate of uncollectable customer accounts. It is known as a "contra" account because it is listed with the assets, but it will have a credit balance instead of a debit balance. For balance sheet purposes, it is a reduction of accounts receivable.
Assets: Things of value held by the business. Assets are balance sheet accounts. Examples of assets are cash, accounts receivable, and furniture and fixtures.
Balance sheet: Also called a statement of financial position, it is a financial "snapshot" of your business at a given date in time. It lists your assets, your liabilities, and the difference between the two, which is your equity, or net worth.
Capital: Money invested in the business by the owners. Also called equity.
Cash method of accounting: If you use the cash method, you record income only when you receive cash from your customers. You record an expense only when you write the check to the vendor.
Chart of accounts: The list of account titles you use to keep your accounting records.
Closing: Closing the books refers to procedures that take place at the end of an accounting period. Adjusting entries are made, and then the income and expense accounts are "closed." The net profit that results from the closing of the income and expense accounts is transferred to an equity account such as retained earnings.
Corporation: A legal entity, formed by the issuance of a charter from the state. A corporation is owned by one or more stockholders.
Cost of goods sold: Cost of inventory items sold to your customers. It may consist of several cost components, such as merchandise purchase costs, freight, and manufacturing costs.
Credit memo: Writing off all or part of a customer's account balance. A credit memo would be required, for example, when a customer who bought merchandise on account returned some merchandise, or overpaid on their account.
Credits: At least one component of every accounting transaction (journal entry) is a credit. Credits increase liabilities and equity and decrease assets.
Current assets: Assets that are in the form of cash or will generally be converted to cash or used up within one year. Examples are accounts receivable and inventory.
Current liabilities: Liabilities payable within one year. Examples are accounts payable and payroll taxes payable.
Debit memo: Billing a customer again. A debit memo would be required, for example, when a customer has made a payment on their account by check, but the check bounced.
Debits: At least one component of every accounting transaction (journal entry) is a debit. Debits increase assets and decrease liabilities and equity.
Depreciation: An annual write-off of a portion of the cost of fixed assets, such as vehicles and equipment. Depreciation is listed among the expenses on the income statement.
Double-entry accounting: In double-entry accounting, every transaction has two journal entries: a debit and a credit. Debits must always equal credits. Double-entry accounting is the basis of a true accounting system.
Drawing account: A general ledger account used by some sole proprietorships and partnerships to keep track of amounts drawn out of the business by an owner.
Equity: The net worth of your company. Also called owner's equity or capital. Equity comes from investment in the business by the owners, plus accumulated net profits of the business that have not been paid out to the owners. Equity accounts are balance sheet accounts.
Expense accounts: These are the accounts you use to keep track of the costs of doing business: where your money goes. Examples are advertising, payroll taxes, and wages. Expenses are income statement accounts.
Fixed assets: Assets that are generally not converted to cash within one year. Examples are equipment and vehicles.
Foot: To total the amounts in a column, such as a column in a journal or a ledger.
General ledger: A general ledger is the collection of all balance sheet, income, and expense accounts used to keep the accounting records of a business.
Income accounts: These are the accounts you use to keep track of your sources of income. Examples are merchandise sales, consulting revenue, and interest income.
Income statement: Also called a profit and loss statement or a "P&L." It lists your income, expenses, and net profit (or loss). The net profit (or loss) is equal to your income minus your expenses.
Inventory: Goods you hold for sale to customers. Inventory can be merchandise you buy for resale, or it can be merchandise you manufacture or process, selling the end product to the customer.
Journal: The chronological, day-to-day transactions of a business are recorded in sales, cash receipts, and cash disbursements journals. A general journal is used to enter period end adjusting and closing entries and other special transactions not entered in the other journals. In a traditional, manual accounting system, each of these journals is a collection of multi-column spreadsheets usually contained in a hardcover binder.
Liabilities: What your business owes creditors. Liabilities are balance sheet accounts. Examples are accounts payable, payroll taxes payable, and loans payable.
Long-term liabilities: Liabilities that are not due within one year. An example would be a mortgage payable.
Merchandise inventory: Goods held for sale to customers.
Net income: Also called profit or net profit, it is equal to income minus expenses. Net income is the bottom line of the income statement (also called the profit and loss statement).
Partnership: An unincorporated business with two or more owners.
Post: To summarize all journal entries and transfer them to the general ledger accounts. This is done at the end of an accounting period.
Prepaid expenses: Amounts you have paid in advance to a vendor or creditor for goods or services. A prepaid expense is actually an asset of your business because your vendor or supplier owes you the goods or services. An example would be the unexpired portion of an annual insurance premium.
Prepaid income: Also called unearned revenue, it represents money you have received in advance of providing a service to your customer. Prepaid income is actually a liability of your business because you still owe the service to the customer. An example would be an advance payment to you for some consulting services you will be performing in the future.
Profit and loss statement: Also called an income statement or "P&L." It lists your income, expenses, and net profit (or loss). The net profit (or loss) is equal to your income minus your expenses.
Proprietorship: An unincorporated business with only one owner.
Reserve for bad debts: Also called allowance for bad debts, it is an estimate of uncollectable customer accounts. It is known as a "contra" account because it is listed with the assets, but it will have a credit balance instead of a debit balance. For balance sheet purposes, it is a reduction of accounts receivable.
Retained earnings: Profits of the business that have not been paid to the owners; profits that have been "retained" in the business. Retained earnings is an "equity" account that is presented on the balance sheet and on the statement of changes in owners' equity.
Sole proprietorship: An unincorporated business with only one owner.
Trial balance: A trial balance is prepared at the end of an accounting period by adding up all the account balances in your general ledger. The debit balances should equal the credit balances.
Unearned revenue: Also called prepaid income, it represents money you have received in advance of providing a service to your customer. It is actually a liability of your business because you still owe the service to the customer. An example would be an advance payment to you for some consulting services you will be performing in the future.
Cash vs. Accrual Accounting
There are two basic accounting methods available to most small businesses: cash or accrual.
Cash method. If you use the cash method of accounting, you record income only when you receive cash from your customers. You record an expense only when you write the check to the vendor. Most individuals use the cash method for their personal finances because it's simpler and less time-consuming. However, this method can distort your income and expenses, especially if you extend credit to your customers, if you buy on credit from your suppliers, or you keep an inventory of the products you sell.
Accrual method. With the accrual method, you record income when the sale occurs, whether it be the delivery of a product or the rendering of a service on your part, regardless of when you get paid. You record an expense when you receive goods or services, even though you may not pay for them until later. The accrual method gives you a more accurate picture of your financial situation than the cash method. This is because you record income on the books when it is truly earned, and you record expenses when they are incurred. Income earned in one period is accurately matched against the expenses that correspond to that period, so you get a better picture of your net profits for each period.
Pros and cons. The cash method is easier to maintain because you don't record income until you receive the cash, and you don't record an expense until the cash is paid. With the accrual method, you will typically record more transactions. For example, if you make a sale on account (or, on credit), you would record the transaction at the time of the sale, with an entry to the receivables account. Then, when the customer pays their bill, you will record the receipt on account as another transaction. With the cash method, the only transaction that is recorded is when the customer pays the bill. If you are using computer software to do your accounting, this is probably not a big concern, since the computer program automates much of the extra effort required by the accrual method.
Another issue to be considered is the accounting method you use for tax purposes. For convenience, you probably want to use the same method for your internal reporting that you use for tax purposes. However, the IRS permits you to use a different method for tax purposes. Some businesses can use the cash method for tax purposes. If you maintain an inventory, you will have to use the accrual method, at least for sales and purchases of inventory for resale.
We recommend the accrual method for all businesses, even if the IRS permits the cash method, because accrual gives you a clearer picture of the financial status of your business. You probably need to keep a record of accounts receivable and accounts payable anyway, so you are already keeping track of all the information needed to do your books on the accrual basis. If you are using a computer program, there really isn't much extra effort involved in using the accrual
-entry accounting is the basis of a true accounting system.
In double-entry accounting, every transaction in your business affects at least two accounts, since there is at least one debit and one credit for each transaction. Usually, at least one of the accounts is a balance sheet account. Entries that are not made to a balance sheet account are made to an income or expense account. Income and expenses affect the net profit of the business, which ultimately affects owner's equity. Each transaction (journal entry) is a real-life example of the accounting equation (assets = liabilities + owner's equity).
Some simple accounting systems do not use the double-entry system. You will have to choose between double-entry and single-entry accounting. Because of the benefits described above, we recommend double-entry accounting. Many accounting programs for the computer are based on a double-entry system, but are designed so that you enter each transaction once, and the computer makes the corresponding second entry for you. The double-entry part goes on "behind the scenes," so to speak.
You also need to decide whether you will be using the cash or accrual accounting method. We recommend the accrual method because it provides a more accurate picture of your financial situation.
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