When running a business, it is important to perform calculations related to profit, sales, purchases, and other financial figures using proper financial formulas and accounting methods.
Keeping accounts is not difficult, but it can be time-consuming and tedious. Like most activities, however, once the basics of bookkeeping are learned, many people wonder why they were ever afraid of it.
Books, software programs, and courses on how to read and prepare financial statements are widely available through the internet, community education centers, colleges, universities, and Small Business Development Centers.
Many business owners consider proper accounting and bookkeeping to be one of the most important parts of running a successful business. For example, one-third of the Australian business owners surveyed for this book stated that staying on top of accounts and tax obligations was their number one piece of advice for business success.
Although this section is not intended to be a complete introduction to accounting and bookkeeping, the following is a brief overview — arranged alphabetically — of some important financial terms every business owner should understand.
Audits
An audit is the examination of a company’s financial records by an outside party, usually a professional accounting firm or a government agency.
Audits of small businesses are often conducted randomly by government authorities, although some businesses may be audited regularly depending on local laws and regulations. If authorities suspect dishonesty in financial reporting, a more extensive investigation may take place. This can involve reviewing every transaction made over several years.
To avoid heavy fines, legal penalties, or even imprisonment, business owners should never falsify accounts, hide revenue, or manipulate financial records.
Balance Sheets
A balance sheet shows how well or poorly a business is performing by listing its assets and liabilities in one document.
- Assets include what the business owns, such as cash, inventory, buildings, equipment, and vehicles.
- Liabilities include what the business owes, such as loans, unpaid bills, taxes, and salaries.
Balance sheets are called “balance sheets” because the figures on both sides should balance correctly.
Basic Bookkeeping
Most small businesses record financial information in:
- a cash book for receipts and payments,
- a petty cash book for small daily expenses such as paper, pens, transport, or refreshments,
- a customer account book for recording credit sales and invoices,
- a purchases book for purchases not covered by petty cash, and
- a wage book if the business employs workers.
The term “book” does not necessarily mean paper records. Today, most accounting information is stored electronically using computers and accounting software.
Spreadsheet and accounting software programs can automatically debit and credit accounts, reducing human errors and improving accuracy.
Important financial documents that should always be collected and safely stored include:
- receipts and invoices,
- checkbook stubs and canceled checks,
- bank statements, and
- tax records required by law.
Break-Even Point
A business reaches its break-even point when the money earned from sales equals the total money spent on costs and expenses.
Calculating the break-even point helps determine how many products need to be sold — or how many customers need to be served — before the business starts making a profit.
To calculate the break-even point, a business must determine:
- fixed costs,
- variable costs, and
- the selling price per unit.
Fixed Costs
Fixed costs remain relatively constant regardless of production levels. Examples include:
- rent,
- monthly salaries,
- insurance,
- loan interest, and
- depreciation.
Variable Costs
Variable costs increase as production increases. Examples include:
- raw materials,
- hourly labor,
- electricity, gas, and water,
- transportation, and
- sales commissions.
Cash Register Sales
Most modern cash registers and point-of-sale systems can separate products into categories and subcategories. Every purchase made is automatically recorded, showing what was bought and when it was purchased.
This information helps entrepreneurs:
- eliminate products that are not selling,
- stock more of the products that sell well, and
- determine the profitability of specific merchandise.
Cost of Goods Sold
The cost of goods sold (COGS), also known as the cost of sales, measures how much it costs to produce a product or sell merchandise.
For manufacturers, it reflects production costs. For retailers, it reflects the cost of purchasing inventory for resale. Monitoring COGS helps determine whether too much money is being invested in inventory.
Inventory
Inventory refers to the total number of products a business has available for sale, including goods on display and in storage. For manufacturers, inventory also includes raw materials used in production.
Good inventory management is essential. A business that runs out of important products or materials may lose customers and revenue. On the other hand, purchasing too much stock can tie up valuable cash.
Successful inventory management aims to maximize profits while minimizing unnecessary investment in stock. Accurate records and reliable suppliers are extremely important in achieving this balance.
Ledger Books
As a business grows, it may require a set of ledgers. A ledger is a detailed accounting record.
Sales Ledger
A sales ledger tracks individual customer accounts and identifies valuable customers.
Purchases Ledger
A purchases ledger stores information about suppliers and purchasing activities. It can help determine which suppliers may offer discounts or trade credit.
General Ledger
A general ledger contains all sales, purchases, income, and expenditure information for the business.
Ledgers usually operate under a double-entry accounting system, where every transaction is recorded twice — once as a debit and once as a credit.
For example, a sale made on credit is recorded as:
- a debit in the customer’s account, and
- a credit in the business’s general ledger.
Because ledger accounting can become complex, business owners may need additional training or professional assistance.
Monthly Net Profit
To calculate monthly net profit, add all monthly sales revenue and subtract:
- labor costs,
- material and equipment costs,
- taxes,
- operating expenses, and
- inventory expenses.
The remaining amount is the business’s monthly net profit.
Profits
A profit is the amount of money remaining after all expenses have been paid. There are generally three types of profit:
Gross Profit
Gross profit is the total sales revenue before expenses are deducted.
Operating Profit
Operating profit shows how much money remains after deducting operating expenses directly related to producing and selling products or services.
Net Profit
Net profit is the final amount remaining after all expenses, taxes, interest, and other costs have been deducted.
Taxes
Almost every business, regardless of size, must register with local or national tax authorities to collect and pay taxes such as sales tax or VAT (Value Added Tax).
After registration, the business is usually issued a tax identification number and provided with the required tax forms and procedures. In many countries, businesses must submit tax reports monthly or quarterly.
Final Thoughts
These financial tools and accounting terms are extremely important in business management. Failing to understand at least some of these concepts can prevent a business from growing properly or even cause it to fail.
Entrepreneurs should take time to improve their financial knowledge by reading books, studying online resources, attending courses, and learning from experienced accountants, business experts, and fellow entrepreneurs.