Bookkeeping Terminology Explained: Key Terms Every Business Owner Should Know

Knowing basic accounting terms is a must for every business owner, whether the business is small or large. It always lands high if you want to turn your business into a thriving organtisation. Surely, you’ve experienced this nearly every time you called your accountant and were feeling more uncertain about your financial situation, didn’t you?

That’s why you need to understand some key principles of accounting.

We’ve compiled all the necessary terms in this blog, you should know.

Let’s delve deeper and thoroughly understand each term with interesting examples!

Cash flow

Cash flow is referred to as a snapshot of your finances, It records all inward and outgoing transactions for your company over a specified time frame.

By deducting the ending cash balance from the beginning cash balance, one can find the net cash flow for a certain period of time. A positive figure shows that more money came into the company than left, whilst a negative figure shows the opposite.

Let’s take a simple example to make you understand more clearly –

Suppose your company started in April with $10,000 in the bank. For the month, you receive payments from clients in a total of $5, 000, and you pay bills at a amount of $3,000. At the end of April, your cash balance would be:

Beginning Cash Balance: $10,000

Incoming Payments: $5,000

Outgoing Payments: $3,000

= Ending Cash Balance: $12,000

Subtract the beginning balance from the ending balance to find the net cash flow:

Ending Cash Balance: $12,000

Beginning Cash Balance: $10,000

= Net Cash Flow: $2,000

From the above example, the net cash flow is positive $2,000, indicating that more money came into the company than went out during April.

Cash-flow forecast

A cash-flow forecast is comparing your past cash-flow statements with estimated income and expenses, knowing how much money will pass through the company in the future is beneficial to the enterprise.

Benefits of cash-flow forecast –

• You can do new business planning based on investments and liabilities.
• You can determine when to invest in the business.
• You can determine when to pay off debts or to pay yourself.

Let’s take a simple example to make you understand more clearly –

Assume, you run a floral shop.

By maintaining a cash-flow forecast, you can predict your upcoming income from sales and expect expenses such as flower costs, rent, wages, etc.

With this insight, you can think of planning to invest in new stuff during a profitable month, pay off expenses when cash flow is strong, or allocate funds for yourself as a business owner’s salary.

Income statement

An income statement shows the details of net profit a company makes in a specific period of time, based on all income, expenses and profits. The top of the report displays the revenue earned, from which different costs (expenses) are deducted until all costs are covered, yielding net income.

Let’s take a simple example to make you understand more clearly –

Imagine you are running a small bakery that earns $50, 000 in revenue over a quarter.

Throughout the period, it suffers with $30,000 in expenses from the revenue, your bakery’s income statement would show a net income of $20,000 for that quarter. These numbers show the profit of the bakery after all cost cuts.

Financial statement

A compilation of all the reports detailing every financial transaction a business has done is called a financial statement. The cash-flow statements, income statement, and profit and loss (P&L) are all included. A financial statement is an invaluable resource for pinpointing the precise performance of your company.

Let’s take a simple example to make you understand more clearly –

Imagine any small business, its financial statement would include a cash-flow statement showing the money received from clients and payments made to suppliers. The income statement of the company would list all the shop’s income from sales and expenses like rent and other wages. At the end, the profit and loss statement would summarize whether the shop made a profit or incurred a loss after all expenses are accounted for over a particular period, like a month or a year.

Gross & Net Profit

The profit you make after subtracting the direct cost of producing a product or service is called gross profit.

And the amount of money a business has left over after paying all other costs, such as salaries, rent, debt repayment, phone bills, and other running expenditures, is known as net profit.

Let’s take a simple example to make you understand more clearly –

Suppose you own a bakery and you sell each cake for $50. $20 is your labor and making cost.

When you subtract the direct costs ($20) from the selling price ($50), you’re left with a gross profit of $30 per cake.

Now, let’s consider other expenses such as the salary, rent, utilities, and phone bills, which total $15 per cake. After paying these additional costs from your gross profit of $30, you have a net profit of $15 per cake. This net profit is what you ultimately keep as earnings from each sale after covering all your expenses.

Balance Sheet

A balance sheet keeps a record of the company’s financial history in the following categories:

• Assets comprise real estate, machinery, and automobiles.
• Liabilities comprise debts, loans, and other credit-based purchases.
• The value of any assets that the owners may claim is known as owner’s equity.

Let’s take a simple example to make you understand more clearly –

Here’s a simple example of a balance sheet for a small business:

Balance Sheet for ABC Company as of December 31, 2023

Assets:

– Real Estate: $150,000

– Machinery: $50,000

– Automobiles: $30,000

Total Assets: $230,000

Liabilities:

– Bank Loan: $100,000

– Credit Card Debt: $5,000

Total Liabilities: $105,000

Owner’s Equity:

– Owner’s Investment: $100,000

– Retained Earnings: $25,000

Total Owner’s Equity: $125,000

Total Liabilities and Owner’s Equity: $230,000

The above balance sheet shows that the company has total assets of $230,000, which are financed by a combination of liabilities ($105,000) and owner’s equity ($125,000). Real estate, machinery, and automobiles are included in tangible assets, while liabilities consist of a bank loan and credit card debt. Once all liabilities have been settled, owners’ equity represents the value that can be claimed.

Gross Margin

The proportion known as gross margin is obtained by dividing gross profit for the same period by revenue. It shows a company’s profitability after subtracting its cost of goods sold.

Let’s take a simple example to make you understand more clearly –

If a company creates $100,000 in revenue and the cost of goods sold is $60,000, the gross profit would be $40,000. The gross margin is calculated by dividing the gross profit by the revenue. So, $40,000 divided by $100,000 equals a gross margin of 40%. This indicates that the company retains 40 cents as profit from each dollar of revenue, after covering the costs directly associated with the products sold.

Gross Profit

When overhead costs are excluded, a company’s gross profit shows its profitability in US dollars. It is computed by deducting the revenue for the same period from the cost of goods sold.

Let’s take a simple example to make you understand more clearly –

Let’s assume your business sold $50,000 worth of products in one month.

The direct costs (cost of goods sold) to produce these products totaled $30,000. To find your gross profit, you subtract the cost of goods sold from your total revenue:

$50,000 (revenue) – $30,000 (cost of goods sold) = $20,000 (gross profit).

This means your business made a gross profit of $20,000 during that month before any overhead costs like rent, utilities, or salaries were deducted.

Accrued Expense

An expense or liability that has been incurred but hasn’t been paid is described by the term Accrued Expense.

Let’s take a simple example to make you understand more clearly –

If your business receives a utility bill for electricity used in December, but you don’t plan to pay it until January, the amount due is considered an accrued expense in December’s financial records. This ensures your financial statements reflect the cost in the same month the electricity was used, maintaining accurate financial reporting.

Cost of Goods Sold (COGS)

Expenses that are directly related to the creation of product or services are called cost of goods sold. The expenses that are needed to run the business are not included in this category.

Let’s take a simple example to make you understand more clearly –

Cost of Goods Sold (COGS) refers to the direct expenses incurred in producing goods or services. For instance, if a manufacturer produces smartphones, the cost of materials such as chips, screens, and batteries, along with the labor costs directly associated with assembling those components, would be considered COGS. On the other hand, expenses like marketing, administrative salaries, or rent for office space would not be included in COGS, as they are not directly related to the production process.

Depreciation

The loss of value in an asset over time is termed depreciation. Normally, an asset cannot be justified in depreciation unless it has significant worth.

Cars and machinery are examples of common assets that must be depreciated. Since depreciation doesn’t directly affect a company’s cash position, it is sometimes classified as a “Non-Cash Expense” when it appears on the income statement.

Let’s take a simple example to make you understand more clearly –

If a company purchases a delivery truck for $50,000 and expects it to have a useful life of 5 years, the company can depreciate the truck by $10,000 each year for five years. This means that each year, $10,000 is recorded as a depreciation expense on the income statement, reducing the company’s taxable income even though no actual cash is spent that year on the truck’s depreciation.

Teams up with YourLegal on this financial journey

With proper understanding of these important accounting concepts allows business owners to manage their finances and make well-informed decisions. Understanding these important words enables entrepreneurs to confidently cover the financial landscape, whether they are tracking cash flow, analyzing income statements, or comprehending balance sheets.

We at YourLegal recognize that financial literacy is critical to the success of any business. To assist companies of all sizes, we provide complete financial services. Our team of professionals is here to be your financial partner at every stage, from bookkeeping and accounting to financial planning and analysis.

Don’t allow doubts regarding your financial situation to hinder your company. Take charge of your financial future by partnering with us today.