Whether you handle your accounting by hand with a ledger or use a computer, the central concepts are all the same. As you develop and grow your small business, there are a variety of accounting concepts you need to understand. While learning about accounting can seem cumbersome, it’s critical to know the basics. After all, the goal of bookkeeping and accounting is to keep track of income and expenses in a way that will ultimately boost your chances of increasing your profits, and on top of that, you also need detailed accounting records to file your taxes.
When you first start talking or reading about accounting, you may stumble upon the following three concepts. These terms all apply to how you keep your records:
- Chart of Accounts: The chart of accounts is a list of all your accounts. This includes business revenue (money you’ve earned from sales), accounts receivable (money your clients owe you) and many other categories. These accounts can be classified as asset, liability, equity, revenue and expense accounts. For instance, if you have an account devoted to cash or inventory, those are assets. But taxes payable (tax that you owe) and accounts payable (bills you owe to your clients) are both liabilities. Essentially, the chart of accounts is a road map to your financial transactions.
- Journals: An accounting journal is where you enter your accounting transactions, which are also called journal entries. This term is a relic from the days where you would enter transactions into a variety of journals and then transfer the numbers to your general ledger. Typically, there is a journal for each account listed in your chart of accounts.
- General Ledger: The general ledger is a book that summarizes all of a business’s account transactions. Now, rather than being a physical book, the ledger is saved on software.
Main Financial Statements
When you put ledger entries into your journals, you can use that information to generate a variety of financial statements or reports. Three of the main statements your business should use include the following:
- Income Statements: Also called a statement of profit and loss, an income statement shows all of a company’s revenues and expenses. Revenues are sales you’ve made, and expenses refer to everything your company has spent from routine costs to payroll to taxes.
- Balance Sheet: A balance sheet is a snapshot of your company’s financial situation. It shows how much the company owes, how much it owns and how much equity the owners have. In other words, it shows liabilities, assets and shareholders’ equity. These numbers need to balance each other. The liabilities plus shareholders’ equity should equal assets.
- Statement of Cash Flow: The cash flow statement shows how much cash you have on hand at any given time. It takes into account the timing of your revenue and expenses and shows how that affects your cash and cash equivalents.
Cash Flow and Profit
Profit is how much your business makes. At its simplest, profit is revenue minus expenses. Although often confused with profits, cash flow is not the same at all. Cash flow simply refers to how cash is flowing in and out of your business. You can actually have a lot of profits but not have any cash, and the reverse is also true.
To explain, imagine you’re using the accrual system of accounting. This means you count revenue when it’s earned rather than when it’s received. A client agrees to buy $100,000 of your goods, but they aren’t going to pay you until they receive the goods. If your expenses are $20,000, you have a profit of $80,000, but you don’t have any cash.
On the other hand, say you get a check from a customer for $10,000. You have all this cash in your bank account, but you have $12,000 that you owe for monthly bills and to your vendors. When you subtract those expenses from your income, you don’t have any profits, but at the moment, you do have cash.
The point of running a business is to turn a profit, but you also need cash on hand to cover your expenses.
Luckily, there are many ways you can increase cash flow:
- Encourage clients to pay their invoices faster by offering discounts or other incentives.
- Conduct credit checks on clients before offering them credit or long invoicing terms.
- Send out invoices immediately. Clients always seem to be more likely to pay when the product or service is fresh on their mind.
- Make paying invoices easier by offering a variety of payment methods.
- Increase your prices.
- Lower your costs by negotiating better prices with your suppliers.
- Form a buying co-op with other businesses so you can buy products in bulk and save.
- Find creative ways to lower your overhead costs such as letting employees work from home to save on office rent.
- Generate cash flow reports and plan accordingly.
- Structure your billing due dates around the times when you anticipate receiving the most revenue.
- Let unused funds earn cash by putting them in an interest-bearing savings account, a certificate of deposit or another predictable investment.
- Consider taking out a line of credit so you can access cash as needed.
On the other hand, there are also a number of practices that can reduce your cash flow. You may want to avoid these actions:
You may want to avoid these actions
- Borrowing money without a clear purposes. Whenever you borrow, make sure you know how you plan to use the funds and can afford to make the loan repayments.
- Taking out loans with high monthly repayments. To preserve cash flow, you may want to look for a longer term and smaller monthly payments.
- Letting your income drop.
- Reducing sales.
- Allowing customers to take excessively long to pay invoices.
- Forgetting to follow up on unpaid invoices.
- Not generating cash flow statements.
- Failing to segment expenses. When you segment expenses or look at different categories separately, you get a sense of where you could save money or generate more income in ways that positively affect your cash flow.
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 percent.
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 percent. 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 percent. 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.
These formulas can be a lot to manage when you’re trying to grow your business, but the more information you have about your finances, the better. With QuickBooks Online, you won’t need a cheat sheet. Instead, you can easily connect this cloud-based accounting software to your bank account to automatically track expenses, and you can pull a variety of reports as needed.