Bookkeeping is essential for any small business, providing the foundation for sound financial management and informed decision-making. For business owners new to this field, the terminology can be daunting. This article will demystify some of the basic bookkeeping terms every small business owner should know, complete with examples.
Assets are resources owned by a business that have economic value and can provide future benefits. Examples include cash, inventory, equipment, and real estate.
Example: A small bakery owns an oven worth $5,000, a delivery van valued at $10,000, and has $2,000 in its bank account. These are all considered assets of the bakery.
Liabilities are obligations the business owes to others. They represent debts or future sacrifices of economic benefits. Common liabilities include loans, accounts payable, and mortgages.
Example: The same bakery has a $3,000 loan from the bank, owes $1,500 to suppliers for ingredients, and has an outstanding mortgage of $50,000 on its building. These are the bakery's liabilities.
Equity represents the owner’s interest in the business after liabilities have been deducted from assets. It is also known as owner’s equity or shareholder’s equity. Equity can increase through profits and additional investments and decrease through losses and withdrawals.
Example: The bakery's assets total $17,000 ($5,000 oven + $10,000 van + $2,000 cash). Its liabilities total $54,500 ($3,000 loan + $1,500 suppliers + $50,000 mortgage). Therefore, the owner's equity is -$37,500 ($17,000 assets - $54,500 liabilities).
Revenue is the income earned from the sale of goods or services. It is often referred to as sales or turnover. Revenue is a crucial indicator of a business's financial performance.
Example: The bakery sells $20,000 worth of bread, cakes, and pastries in one month. This $20,000 is the bakery's revenue for that month.
Expenses are the costs incurred in the process of earning revenue. They include rent, utilities, salaries, and supplies. Tracking expenses is vital for managing profitability and budgeting.
Example: In the same month, the bakery spends $2,000 on ingredients, $3,000 on salaries, $1,000 on utilities, and $2,000 on rent. These are the bakery's expenses for the month.
Accounts receivable represent money owed to the business by customers who have purchased goods or services on credit. Efficient management of accounts receivable is crucial for maintaining cash flow.
Example: The bakery supplies bread to a local restaurant and invoices them $500, giving them 30 days to pay. This $500 is recorded as accounts receivable until the restaurant pays the invoice.
Accounts payable are amounts the business owes to suppliers for goods or services received but not yet paid for. Keeping track of accounts payable ensures timely payments and helps maintain good supplier relationships.
Example: The bakery receives a delivery of flour and sugar worth $700 from a supplier and agrees to pay the invoice in 15 days. This $700 is recorded as accounts payable.
The general ledger is a comprehensive record of all financial transactions of the business. It contains accounts for assets, liabilities, equity, revenue, and expenses. The general ledger serves as the primary source of financial information for preparing financial statements.
Example: When the bakery purchases ingredients, pays salaries, or makes sales, each transaction is recorded in the general ledger under the appropriate accounts, such as "Ingredients Expense," "Salaries Expense," or "Sales Revenue."
A trial balance is a report that lists the balances of all ledger accounts at a particular point in time. It is used to verify that the total debits equal the total credits, ensuring the books are balanced.
Example: At the end of the month, the bakery prepares a trial balance to ensure that the sum of all debit balances (e.g., expenses, assets) equals the sum of all credit balances (e.g., revenue, liabilities, equity).
The balance sheet is a financial statement that provides a snapshot of the business’s financial position at a specific date. It summarizes assets, liabilities, and equity, giving insight into the company’s net worth.
Example: On December 31st, the bakery's balance sheet shows total assets of $17,000, total liabilities of $54,500, and owner’s equity of -$37,500.
The income statement, also known as the profit and loss statement, shows the business’s financial performance over a period. It details revenue, expenses, and net profit or loss, helping assess profitability.
Example: For the month of January, the bakery's income statement shows $20,000 in revenue and $8,000 in expenses, resulting in a net profit of $12,000.
The cash flow statement outlines the inflows and outflows of cash within the business over a period. It categorizes cash flows into operating, investing, and financing activities, providing insight into the company’s liquidity.
Example: In January, the bakery's cash flow statement shows $15,000 received from sales (operating activities), $5,000 spent on a new oven (investing activities), and $2,000 in loan repayments (financing activities).
Double-entry bookkeeping is a system where every financial transaction affects at least two accounts. It ensures the accounting equation (Assets = Liabilities + Equity) remains balanced. This method enhances accuracy and helps detect errors.
Example: When the bakery purchases $500 worth of ingredients, it records a debit to the "Ingredients Expense" account and a credit to the "Cash" account.
Depreciation is the process of allocating the cost of a tangible asset over its useful life. It reflects the wear and tear on assets like machinery and equipment. Depreciation is an essential concept for accurately reporting asset values and expenses.
Example: The bakery’s $5,000 oven has a useful life of 5 years. Each year, the bakery records $1,000 as depreciation expense ($5,000 / 5 years) to account for the decreasing value of the oven.
Accrual accounting records revenues and expenses when they are earned or incurred, regardless of when cash is received or paid. This method provides a more accurate picture of financial performance than cash accounting, which records transactions only when cash changes hands.
Example: The bakery delivers a cake to a customer in December and invoices them $200, but the customer pays in January. Under accrual accounting, the $200 is recorded as revenue in December when the cake is delivered, not in January when the payment is received.
Understanding these basic bookkeeping terms, along with relevant examples, is crucial for small business owners to manage their finances effectively. Familiarity with these concepts lays the groundwork for more advanced financial management and strategic decision-making, ultimately contributing to the success and growth of the business.