As a small business owner, you probably have plenty of questions on finance and accounting, unless you run an accounting practice. With so many financial terms, calculations, and accounting strategies, it can be tough to keep it all straight. Whether you hire someone to manage your finances or not, it’s crucial to have a sound knowledge of finance and accounting. Having this background will empower you to have better conversations with your financial professionals and make smarter decisions. Here is a guide to understanding financial terms and processes relevant to small business owners.
Table of Contents:
- Business Accounting Terms
- Understanding Financial Reports
- Assets and Debts
- Expenses and Revenue
- Must-Know Formulas
- Financial Planning and Forecasting
- Inventory and Pricing
- Money Management
- Invoicing Clients
- Small Business Taxes
- Audits and Accounting Help
Whether you handle bookkeeping or hire it out, understanding financial terminology can make small business accounting much clearer. With so many acronyms flying around the finance world, it’s easy to get confused. For example, learning the definition of ASPE reveals this acronym stands for Accounting Standards for Private Enterprises, which is a set of accounting standards.
When you establish your small business, one of the first business decisions you make is how to record financial transactions. There are two primary methods—the cash method and the accrual method of accounting. In the cash accounting method, you record transactions when cash exchanges hands. If you bill a client for services in January but don’t receive payment until March, you record the transaction in March with receipt of the money.
The accrual method is more complex and records each action as it happens, even if cash doesn’t exchange hands immediately. In the client example, you record the initial transaction in January even though you don’t get paid immediately. Small unincorporated businesses often prefer the cash method, but comparing the two methods helps you decide which fits your situation best.
If your business has inventory on hand, it’s a good idea to familiarize yourself with FIFO accounting. FIFO stands for First In, First Out and refers to how you record sales based on changing costs of inventory.
Staying on top of your company’s financial situation helps you spot issues early and make informed decisions. Commonly used financial statements, including income statements, balance sheets, and cash flow statements, provide a picture of your company’s finances in different ways. Understanding what financial statements say about your business allows you to put that information into action.
Balance sheets show your assets, liabilities, and owner’s equity. That includes your inventory valuation, which needs to follow International Financial Reporting Standards (IFRS). Trial balance statements can help you spot posted journal errors. Your trial balance looks at your credits and debits to make sure they’re equal. If you deal with any foreign clients or companies, it’s a good idea to brush up on how to account for foreign currency on financial statements.
Your bank statements are another important piece of the money-management puzzle. Performing weekly bank reconciliations lets you spot errors faster, so you can make corrections before they become a huge issue. This allows you to spot both bank errors and your own errors.
It’s common to look at numbers for the fiscal year or year-to-date, but you can also implement the trailing twelve months (TTM) method for internal use. This option looks at the previous 12 months from the time you generate the report, instead of only looking at the current fiscal year.
As you wrap up other year-end tasks, don’t forget to do a year-end cleaning of your accounting books for a fresh start to the new fiscal year. You may also have special year-end reports to run, including the year-end profit and loss report, to help plan for next year.
Using online accounting services for small businesses can help you keep track of data needed for financial statements. Cloud-based online accounting offers a secure way to store information that’s easily accessible from any mobile device. And with QuickBooks, you can handle many day-to-day tasks, such as creating receipts and invoicing clients.
Your company’s assets encompass anything of value. That includes intangible assets, which have no physical form, and contra assets, which have a zero or negative balance on your balance sheet. It’s also a good idea to familiarize yourself with related calculations, such as asset turnover, or the ratio that shows how efficiently you convert assets into sales.
Many companies also have debts to consider. Your debt ratio compares debts to total assets to see how much you rely on debt to cover business costs. Another calculation to consider is times interest earned (TIE), which shows your ability to pay back debts. You can use an earnings before interest and taxes (EBIT), or earnings before interest, taxes, depreciation, and amortization (EBITDA) to calculate TIE. If you’re struggling with debt, you may find that a licensed insolvency trustee can help you avoid insolvency or bankruptcy.
Staying on top of your expenses is an important part of managing your finances. The arrears account balance shows accumulated bills that you still owe. Getting caught up on these past due invoices and debts helps get you back on track. You can also use your aged accounts payable report to look at the upcoming payments.
Analyzing what comes into your business is another part of the job. Your operating cash flow is the money you generate from the main activities your business handles. It shows the amount of cash you’re bringing into your business to cover expenses and turn a profit. Your net sales include all of the revenue earned from sales minus returns, allowances, and discounts.
Those numbers alone don’t show your profits, though. Calculating your net profit margin gives a percentage to represent your profit margins. Another calculation to look at when evaluating your financial situation is free cash flow. This is the amount of cash you generate after paying bills and reinvesting into the company.
Quality accounting goes far beyond just tracking income and expenses or projecting cash flow. It provides you with a variety of tools you can use to set goals and assess your profitability. Ideally, you should understand the following accounting formulas and how to use them.
Also called the balance sheet equation, the accounting equation adds together liabilities and owner’s equity, and the result should be equal to the company’s assets. As explained above, this equation is showcased on your balance sheet, and it looks like this:
Liability + Owner’s Equity = Assets
You can also rewrite this equation as assets minus liability equals owner’s equity. Note that liabilities refer to all the debts your company owes, and this includes operating expenses such as payroll, leases and utilities. Assets are everything your company owns, and owner’s equity, of course, is the amount of equity the owners and shareholders have in the company.
The current ratio helps you compare your current assets to your liabilities. To find this ratio, just divide your current assets by your current liabilities.
Current Assets / Current Liabilities = Current Ratio
For instance, if your current assets are worth $500,000 and your current liabilities are $250,000, your ratio is 2. Lenders look at the current ratio when offering funding, and generally, they want to see approximately 1.2 or higher, but that can vary depending on your industry. If your ratio is less than 1, that indicates you don’t have enough assets to cover your liabilities.
Variable Cost Ratio
Used by retailers or anyone else who sells goods, the variable cost ratio compares your total variable expenses to your net sales.
Variable Costs / Net Sales = Variable Cost Ratio
For instance, if you incur $60,000 in variable costs and you have $100,000 in product sales, your variable cost ratio is 60%.
From the above point, you can also find your contribution margin, which is 1 minus your variable cost ratio. In the above formula, that’s 40%. Your contribution margin is the percentage of each sale that’s contributed to your business. In other words, it’s the percentage of each sale that’s freely available to cover fixed costs and/or become profits. Here’s the formula:
Variable Costs / Net Sales = Contribution Margin
Your break-even point is the point at which you break even. To put it another way, it is the point at which your sales cover your costs. You don’t turn a profit, but you also don’t lose anything. To calculate your break-even point, you can use a few different equations:
Fixed Costs / Contribution Margin = Break-Even Sales Dollars
Fixed Costs / Per Unit Contribution Price = Break-Even Units
To break it down, your fixed costs are the expenses you pay every month to keep your business running, and they include office rent, insurance premiums and similar costs. As explained above, your contribution margin is 1 minus your variable cost ratio, and the per unit contribution price is the amount each sale contributes to your business. In other words, it’s the sale price of your product minus its variable costs.
To give you an example, say your fixed costs are $10,000 per month. You sell pies for $20 each, and you spend $12 making each pie. Your variable cost ratio is $12 / $20 = 60%. That makes your contribution margin 40 percent. When you divide your fixed costs $10,000 by 40 percent, the result is $25,000. You need to make that amount of sales to break even every month. Then, to find out how many pies (units) you need to sell, you can divide this number by $20, which means you need to sell 1,250 pies.
If you want to find units straight off the bat, you take your fixed costs ($10,000) and divide that by your contribution rate. As you spend $12 making each pie and you sell each pie for $20, your contribution rate is $8. When you divide $10,000 by $8, you also get 1,250. Now you know that you need to sell that many pies to cover all your expenses.
That said, you need to use this formula carefully. It can be instrumental for helping you set sales targets, but it doesn’t work that well in situations where your fixed costs are constantly changing.
Target Net Income
To calculate net income, you simply use this equation:
Revenues – Expenses = Net Income
In some cases, you may want to set a target net income. This is just a target for how much you want to earn. You can simply use this basic equation and try to find ways to increase revenue or lower expenses until you get at the target income you want. But you may want to break down your goal into per unit sales.
Say you’re in marketing and charge $5,000 per month to every client who uses your services. At the same time, you incur $500 in variable costs for every client per month. Based on those numbers, your per unit contribution price is $4,500, and your contribution ratio is 90 percent. You also have $2,000 in fixed costs per month. You want to earn $100,000 this month. To figure out how many marketing packages you need to sell, you can use this equation:
(Target Income Level + Fixed Costs) / Expected Contribution Margin = Amount of Sales You Need to Make
When you plug in the numbers, that becomes ($100,000 + $2,000) / 0.90 = $113,333
To make $100,000 in income, you need $113,333 in sales. If you divide that amount by $5,000, you find that you need to sell 22.67 marketing packages. So you round that up to 23, and you know you need to hit this sales number to make your income goal for the month.
Gross Profit = Revenue – Cost of Goods Sold (COGS)
Keep in mind that COGS only takes into account the direct costs you incur producing goods, such as labour, materials, equipment used in production and utilities for your manufacturing facility. It does not take into account other fixed costs or taxes.
Essentially, gross margin puts your gross profits into a percentage, and it shows you which portion of your revenue is gross profit. You can calculate gross margin with this formula:
(Revenue – COGS) / Revenue = Gross Profit Margin
To give you an example of this formula in action, say you earned $50,000 in revenue last year. You also spent $20,000 making your goods. When you plug these values into the above formula, you get the following: ($50,000 – $20,000) / $50,000 = 0.60. In other words, 60 percent of all the revenue you receive does not need to be used to produce your goods. You can use that portion of your revenue to cover fixed costs and taxes, but most importantly, part of that gross margin has the potential to be turned into profit.
To calculate price variance, use this formula:
(Actual Cost Incurred – Standard Cost) x Actual Quantity = Price Variance
As you remember from above, there are a lot of formulas that rely on your COGS, your variable costs and your direct costs. This formula helps you assess the difference between the actual costs you’ve incurred and the costs you’re using to calculate your gross profits or margins.
To explain, say a unit is projected to cost $5 to produce, but after you add up all the numbers and take into account all the expenses, you ended up spending $6 per item. When you subtract your standard cost from your actual cost, you get $1. If you sell 100 units, your price variance is $100. You incurred $100 more in expenses than you anticipated.
If your actual costs incurred are less than your standard costs, you end up with a negative number. For instance, if your actual costs are just $4, your price variance is -$100. You saved $100. This formula can help you figure out how unplanned or unusual expenses affect your bottom line, but you can also use this formula to help you identify when you should adjust your COGS or other inputs.
The efficiency variance helps you see the differences between the actual and expected usage of supplies or labour. Typically, this formula is used to assess the efficiency of the materials and labour involved in manufacturing, but you can also use efficiency variance formulas to calculate the efficiency of services.
To explain, say you thought it would take 20 hours to do a project but it actually took you 25 hours. You charged the client $1,000, which is the equivalent of $50 per hour, but since the project wasn’t as efficient as expected, you ended up at a lower hourly rate. To put a number on the inefficiency, you can subtract your budgeted time from your actual time to get five hours. Then, you can multiply that by the projected $50 hourly rate to get $250. If you hadn’t spent that time on this project, you could have invested that time into other work that paid $50 per hour and made those extra funds.
The efficiency variance formula can vary a bit depending on what you want to assess, but the basic formula is as follows:
(Actual Usage or Hours – Standard Usage or Hours) x Standard Rate or Cost = Efficiency Variance
To give you another example of this formula at work, imagine you buy wood to make bird houses. You plan to use 100 pieces of plywood every month, but you actually end up using just 80 pieces. You subtract the standard from the actual use and get -20. When you multiply that amount by the cost of each unit, imagine the cost is $10, you get -$200. Based on this number, you can see that you lost $200 or spent $200 more on plywood than anticipated. Luckily, in this situation, you can just buy less plywood next time or use the remaining amount the next month.
Now, think about what happens if the situation goes another way. You anticipate using 80 pieces of plywood but actually use 100. Now, your efficiency variance is $200. You have spent $200 more than expected or budgeted. But when you take a closer look at your manufacturing process, you realize that your projections are based on using every single bit of every piece of plywood, but in reality, the design of your birdhouses doesn’t make that possible. You actually need 100 pieces but you’re going to be left with some scrap wood. So, based on what you learned from this formula, you reassess your goals, and now, you plan to use 100 pieces of plywood per month.
Variable Overhead Variance
With this formula, you can figure out the difference between your actual and projected variable overhead. Variable costs are the prices that change in relation to production output, and they include production supplies, utilities for equipment and wages. Typically, as you produce more goods, these costs may fall on a per unit basis, but they often tend to increase if production drops. To give you a basic example of how and why this happens, imagine you spend $100,000 leasing a piece of equipment for a year. If you make 100,000 items, the per unit cost of your lease is just $1, but if you only make 100 units, the per unit cost for this lease is $1,000. This is a very simplistic explanation of why these overhead costs are called variable.
To calculate variable overhead efficiency, you need to break down your standard and actual overhead costs into a rate per labour hour. Then, you can use this formula:
Actual Hours Worked x (Actual Overhead Rate – Standard Overhead Rate) = Variable Overhead Spending Variance
Say your standard overhead rate is $500 per labour hour, but you actually ended up spending $600 per labour hour on variable expenses. Your manufacturing team puts in 10,000 per hour. That leads to this equation: 10,000 x ($600 – $500) = $1 million. You spent $1 million more than you expected.
Ending inventory refers to the value of the goods you have on hand at the end of a reporting period. This number can include your raw materials, raw materials in the midst of manufacturing and finished goods. You can assess your ending inventory just by adding up all the value of these items, but you can also use this equation:
COGS – Beginning Inventory – Purchases = Ending Inventory
By moving around some of these values, you can also use ending inventory to calculate your COGS. To do this, you take your beginning inventory. Then, you add in your purchases and subtract your ending inventory. Now you know your COGS.
Financing Your Business
Many small businesses rely on external funding, especially when you start or want to expand your business. Understanding financing terminology and the details involved can support you in deciding which option works best for your situation. That way, you have the working capital you need to grow.
Venture capital is money you receive from individuals or institutions to fund your business. The closely related adventure capital provides funding for projects typically considered too risky for traditional venture capitalists, often for untested projects. Other small businesses may look to capital markets as a funding option. If you prefer a commercial business loan, a general security agreement (GSA) lets you secure the debt with specific tangible and intangible assets.
Sometimes you just need short-term funding to help with a project or expansion. Invoice factoring offers a short-term financing solution where you sell your outstanding invoices to a factoring company for a cash advance. Another option is asset-based financing. This short-term loan option allows you up to 90% of your asset’s value as cash, with the asset serving as collateral. If you’re looking to secure an asset, such as real estate or new equipment, a capital lease may be an option.
Before you secure investors, it can be helpful to know your pre-money valuation. That simply means the value of your company before you receive any funding. Many investors want to know this information in order to make their decision.
Financial Planning for Your Business
Every business needs a master budget to keep a positive cash flow and protect profits. It helps calculate the minimum monthly profit you need based on your financial situation. Your budget also comes into play when you calculate what to pay yourself. Part of that decision is whether it’s better to pay yourself a salary or dividends, which may vary based on your finances. Sometimes, even the best budgets go astray. Learning how to use variance analysis supports a comparison of your budgeted vs. actual performance.
Your books give you a picture of your current financial state, but it’s also important to look to the future with sound financial projections that balance optimism and reality. By improving your financial forecasting, you can plan for growth, make informed decisions, and predict potential cash flow issues. It’s also a good idea to understand linear vs. exponential growth as you forecast for your company’s future.
As a business owner, looking to the future helps you grow your company and improve profits. For example, calculating your break-even point tells you the minimum sales you need to stay afloat. Understanding this number provides a baseline goal, lets you calculate your margin of safety. It also informs decisions that help you meet and surpass that break-even point.
Knowing your industry’s beta can help you plan your company’s financial future while effectively managing risks. The Dupont Analysis is another useful tool that looks at your return on equity broken down into three parts. You can use the Dupont Analysis method to help you increase the value of your company going forward.
Sometimes looking at your past performance is the best way to plan for the future so you know what to change and what to keep the same. One example is calculating your gross margin to assess profitability by comparing total revenue to costs of goods sold. Other profitability ratios can better equip you with the information you need to make financial decisions. Creating an income statement projection based on your past revenue and expenses can also help you forecast your finances.
Based on the numbers, your finances can also guide you to the projects to undertake. Calculating the payback period compares the financial risks of each option. If you want to look at the historical results of past investments, you might use the compound annual growth rate to see how those investments have grown. To anticipate future investment growth, you can use the rule of 72, which estimates when your investments should double.
Forecasting is also important for your inventory if you sell physical products. Too much inventory ties up capital on goods that move slowly and take up storage space. Too little inventory can lead to shortages and backorders that leave your customers frustrated. Using inventory forecasting strategies helps you decide how much inventory to produce or order.
Pricing strategies for your goods and services also affect your financial decisions. Consider the following calculations and strategies to price your products:
- Allocating overhead ensures you cover the costs not associated with a particular product.
- The raw materials price index (RMPI) alerts you to fluctuations in prices of raw materials. For example, you might need to bump up your prices to cover the increases.
- Calculating your contribution margin to ensure you cover the variable costs of your product.
- Cost behaviour classifications also assist with pricing by helping identify variable, fixes, step, and fixed costs.
- Using the weighted average method helps you account for fluctuations in the cost to produce goods or buy inventory.
- Job costing looks at the labour, materials, and overhead costs that go into a project to guide pricing services and choosing future projects based on profitability.
- Another pricing issue you might tackle is comparing variable pricing vs. absorption costing
When you’re the boss, you have to think about retirement savings options for you and your employees. Investing in a registered retirement savings plan (RRSP) lets you save money for retirement while lowering your income tax obligation. If you have employees, think about a group registered retirement savings plan (GRRSP), which lets you match employee retirement contributions. You also might consider cliff vesting for your matched retirement funds and other benefits for your employees.
Learning strategies, calculations, and methods used in small business accounting helps you make better financial decisions and understand your company’s finances.
The way you manage your working capital affects your operational efficiency and overall success. Small business management comes with lots of little quirks and important decisions. If your company operates internationally, you have currency exchange to consider.
Another money management issue is business liquidity. Finding the right balance of liquidity helps you keep up with bills, prepare for emergencies, and get approved for financing. Liquidity ratios support your calculation of the company’s ability to cover debts. The quick ratio is one way to calculate your short-term liquidity. By looking at your liquidity, you may find that you’re holding onto too much cash, or that you may need more liquid assets to cover short-term liabilities.
Invoicing your clients efficiently and effectively keeps cash flowing into your business. Understanding different payment terms makes it easier to encourage clients to pay promptly. Accepting different payment methods, such as credit cards, cash, and electronic cheques, increases the chance of getting paid quickly. Remember that certain payment methods come with regulations. If you accept credit or debit cards, you need to understand Payment Card Industry (PCI) compliance, for example.
When you invoice clients, you’ve accounts receivables to manage. You can stay on top of accounts receivable by using ratios and calculations. The receivables turnover ratio shows how often you collect your average accounts receivable during a given period. The days sales outstanding highlights the number of days it takes to collect payment on credit sales.
You may need to occasionally give a refund to satisfy a client. Knowing the basics of handling refunds in your books assists in recording the transaction successfully.
Handling accounting efficiently throughout the year simplifies tax time. Accurate accounting records help you identify deductions and credits you qualify for to save money.
The capital cost allowance allows you to write off larger expenses, such as buildings and furniture, to spread depreciation over several tax years. Knowing when to claim capital cost allowance and keeping accurate records is essential at tax time. If you sell a high-value asset, understanding capital gains and losses can guide your preparation for tax implications. You can also explore ways to optimize capital losses to reduce what you owe on your taxes.
Input tax credits help you recoup part of the GST/HST you pay on certain goods or services used for commercial activities. Tracking eligible expenses is necessary to accurately claim the credit. You may also qualify for the GST/HST credit if your income is less than the GST credit income threshold.
It’s also important to understand how business decisions can impact your tax obligations. If you drive your vehicle for business, you face the decision of whether to use a personal car or company car. Using a company car gives you more tax deduction options, but you can also claim mileage expenses with your personal car.
Small businesses also deal with sales tax and tariffs. Tariffs are taxes added to goods or services when they’re imported from a different country. Knowing how to calculate sales taxes and anticipating the added cost of tariffs, if you import from other countries, allows you to better manage your finances.
When you hear the word audit, your mind likely goes to the Canada Revenue Agency (CRA) audits. But small business self-audits let you assess your overall accounting and operation procedures. It’s a good way to make sure all aspects of your company are efficient and effective.
If you handle your books, consider hiring an accounting firm to handle audits of financial records. Having a professional check your numbers can help you spot potential problems and get personalized advice on improving accounting methods.
Sometimes you may need a little more help with your accounting. A specialist in forensic accounting can search for questionable transactions to check for internal threats, such as theft and embezzlement, and external threats, such as data skimming and cyber theft. Not all companies need services from a forensic accountant, but it’s one way to dig deeper if you suspect a problem.
Should You Hire an Accountant
Not feeling confident in your bookkeeping skills? Hiring a small business accountant takes the pressure off and helps you avoid problems, improve accuracy, and make better financial decisions. Small business vs. big business accounting has significant differences, so finding an accountant who specializes in small businesses may better fit your needs.
Outsourcing your accounting before you run into trouble can save you a lot of stress. No matter what type of support you choose, maximize your time with your accountant or bookkeeper by communicating well and organizing your documents in advance by using an app like QuickBooks.