Accounting is an intricate part of any business. For a business to be sustained, expenses, revenue & profits have to be made, and all of these must be taken into account to ensure proper management of business finances.
Therefore, it is important to understand as many accounting terms as possible, as they always come in handy, even in the areas least expected.
Here are 10 basic Accounting Terms to help you get started:
Financial Statements are written records that show your company’s financial status at a specific point in time. A financial statement includes the balance sheet, income statement & cash flow statement.
A financial statement acts as a “business map” that helps you keep track of your business cash flow in real-time. With a financial statement, you can easily identify modes of operation and drawbacks, review expenses, and determine your company’s financial health status. Keeping track of your financial statement will help you in making the right financial decisions for your company.
Financial Statements are also often used by investors, market analysts, and creditors to evaluate a company’s financial health and earnings potential.
2. Balance Sheet:
A balance sheet, also known as a statement of financial position, is a financial statement that shows the summary and details of a company’s assets(how much your company owns), liabilities(how much your company owes), and shareholder equity(the total amount of money that is attributed to the business owner and its stakeholders) at a specific point in time. It is one of the core financial statements used for business evaluation.
The balance sheet is based on the fundamental equation: Assets= Liability + Equity. Assets must always equal liabilities plus owners’ equity. It must all be balanced, hence the term ‘balance’. For instance, if a telecommunication company generates monthly revenue of N5,000,000 and has an ROI of N2,000,000, the N2,000,000 will go into the shareholder equity account. These revenues will then be balanced on the Assets side of the sheet, appearing as cash, investment, and other assets.
If the company goes on to take a two-year loan from a bank for an amount of N10,000,000, the company’s assets will increase by N10,000,000 and its liabilities will also increase by N10,000,000, which will balance the two sides of the equation. If the company then takes N4,000,000 from investors, its assets will increase by N4,000,000, as will its shareholder equity.
Revenue is any money earned by a business. It is the total amount of income generated from sales of products and services.
Revenue is sometimes mistaken for profit, however, they mean different things. While revenue is the total amount of income generated by a business from sales and services rendered during its normal course of operations, profit is the amount of money realised after deducting the company’s expenses from the total amount of revenue. Profit is also known as Net Income.
4. Income Statement/Profit and Loss statement:
An Income Statement shows the profitability of a business over a specific period of time. It monitors business activity and helps to identify your business’s successes as well as its shortcomings. It is also used to check for any sudden spikes in cost, rather than gradual increments over time.
The Profit & Loss Statement is usually split into 2 sections; Revenue & Expenses. The revenue highlights total sales(total amount of money made) while the expense highlights the cost of labour (total amount of money a business spends.
The Income Statement also works hand-in-hand with the Balance Sheet & Cash Flow Statement to help you analyse and understand the financial status of your business.
5. Cash Flow:
Cash Flow is a term that describes the inflow and outflow of cash in a business. A Cashflow statement accounts for the usage of business cash over a specific period of time.
For instance, if a car dealer purchases new cars to be put up for sale, there is an outflow of money in the business toward the car manufacturers, but when the car dealer sells the cars, there is an inflow of cash from the customers.
Cash Flow can be positive or negative. When there is positive cash flow, a company has more inflow of money but when there is negative cash flow, cash outflow is more.
6. Net Income (NI)/Profit:
This is the amount a business makes after deducting all expenses made within a given period. It is what the business has left over after all expenses, including salary and wages.
For an individual/employee, this is the salary or “take-home” money earned after tax, pension, and health insurance deductions have been made. Net income is calculated by taking the gross income(total revenue) and subtracting expenses from it.
Payroll is the total compensation that a company owes to its employees within a given period of time. It is most times required to be paid on an agreed set date.
A payroll account consists of employee details such as; working hours, gross income, net income, and so on, which are used to determine the accurate salaries. Often, this will appear on the balance sheet as a liability that the company owes if there is accrued vacation pay or any unpaid wages.
Payroll could take days and even weeks to be processed when done manually, but with an efficient payroll accounting software, it can be done within a few minutes.
This is a term that explains the probability of getting an asset converted to cash without negatively affecting its price. In business, liquidity measures how capable your business is, of settling its liabilities.
Before going into business, it is necessary to understand the liquidity of your assets. This will help you predict how capable your business is of paying its bills and sailing through any impending financial struggles. This will also help in sustaining business growth.
9. Return On Investment(ROI):
This is a performance measure that is used to evaluate the financial performance of a business, relative to the amount of money that was invested.
Although closely related, ROI is different from business profit. While ROI deals with the money that was invested in a business and the return realised on that money, profit measures business performance.
To calculate ROI, the return (or profit) of an investment is divided by the cost of the investment and then multiplied by 100 to arrive at a percentage. For instance, if you invested $500 in your business and realised a profit of $500 from sales, then your ROI would be 100%.
10. Burn Rate:
Burn rate measures the rate upon which a company spends its venture capital before generating positive cash flow from operations.
Burn rate is commonly used by business owners to track the amount of monthly cash that their company spends before it starts generating its revenue. In this case, it can be called a measure of negative cash flow since there is only an outflow of cash.
A high burn rate is bad for your business. If your company burns cash at a fast rate, there is a risk of running out of money. Paying close attention to your company’s burn rate will help you easily identify areas where you are overspending and provide you with insights for planning your company’s future.
To reduce the burn rate for a growing business, you can try to cut costs by opting for cheaper means of production and employing fewer employees.
There you have it. 10 Basic Accounting Terms that will serve as some of your many guides as you venture into any business. If you want to be at the top of your business game, then it’s important you familiarise yourself with these accounting terms. Having proper knowledge about these terms is certainly a great start to understanding & determining the well-being of your business.