It’s difficult enough to run a successful business without worrying about balancing your books and understanding your tax bill - that’s what your accountant is for, right? And as well as managing these processes, your accountant may be one of the first you turn to, to discuss business growth and strategy, rightly so. However, if you’re able to ‘speak their language’, you’ll get significantly more value out of this relationship and have a better grasp of the reports and advice your accountant will provide.
With that in mind, here are some fundamental accounting terms and concepts business owners should know.
Profitability is a key business metric, but there are different types which can help you gauge the various contributors to your revenues. These include:
Capital expenditure (CapEx) vs Operating Expenditures (OpEx)
Capex are the funds used to maintain operations or to fuel business growth, either by growing existing operations or by making acquisitions. On the other hand, operating expenditures are those expenses that go towards the running of the business. For example, the purchase of a new shop or office space would constitute as CapEx and be found on a company’s balance sheet. The cost of employing staff to work in the new shop or office space would constitute operating expenditure and would flow through the income statement.
Familiarity with the various elements of the cash flow statement will help you in reconciling your company’s cash position as well as calculating the free cash flow generated by the business - in other words, the amount of cash left over from operations once capital expenditures have been accounted for. Cash flows fall into one of three categories:
Assets, liabilities and equity
Another fundamental principle in accounting is that the books must balance - in other words your assets must be equal to your liabilities and equity. You should think of your assets (e.g. cash, property, inventory or equipment) as those things within your business that generate economic revenues whilst the liabilities (e.g. long term debt) and equity (e.g. capital retained or injected into the business) are those elements that generate economic costs.
Any of the aforementioned profitability measures can be taken as a percentage of revenues to provide the relevant profitability margin. When compared to peers, these can be used in gauging the relative competitiveness of your business. For example, a lower gross margin and operating margin than competitors may indicate that your business is paying a higher rate for similar raw materials and operating expenses.
Cash based accounting vs accruals based accounting
Your income statement will measure the performance of your business, but it’s important to bear in mind that the numbers will be prepared on an accruals basis. That means that revenues/costs are reported when they are earned/incurred, rather than when the cash is actually received/paid.
Return on equity
While the above measures of profitability assess the economic performance of your business in a given period, the return on equity can show you how efficient you have been at generating profit on the amount of equity in your business. This is an important measurement for potential investors, as it will show them how much they can get back for what they invest, and how effectively a business can convert their investment into profit.
Working capital (WC), Accounts payable (A/P) and Accounts receivable (A/R)
WC is the money a business has to maintain its daily operations (i.e. the difference between short term assets and liabilities). It’s extremely important to have a stable working capital, and businesses can maintain this by managing payment inflows and outflows, while also ensuring their growth is steady and done with sufficient available resources.
A/P represents the money a business owes its suppliers for goods or services bought on credit. For example, when a business buys its raw materials from a supplier on credit, it generates an A/P on the liability side of the balance sheet because at some point it will need to pay the supplier with cash.
The opposite to A/P is A/R, which is the money owed to a business by its customers for goods or services bought on credit. As this is counted as money which is owed to your business, it’s considered an asset. Therefore, it’s critical that businesses carefully track these invoices and ensure they are converting these debts into cash in order to maintain sufficient cash at hand to operate their day-to-day business activities.