Some business owners may find accounting confusing, especially if they were never trained in this area. In addition, their accountant may have never explained accounting principles to them in simple terms they can understand.
Overwhelmed, owners may end up ignoring the entire accounting area of their business except for when they are forced to face it during tax season. As a result, they may miss key numbers that can help their company become more successful. Knowing the following five accounting principles can help those business owners who want to get a handle on accounting.
1. Cash Flow
Companies may go out of business not because they lack sales or profit, but because they have too little cash flow. Cash is not the same thing as revenue. Sales happen when a company sells a product or delivers a service, but a company only actually gets cash when it collects payments from the customer. Cash flow is one of the factors that can make a business engine operate and keeps companies moving forward.
You may want to consider creating a plan to ensure you have enough cash to grow your company. The activities that can have a large effect on cash flow are:
- How quickly customers pay the company. The faster they pay, the faster cash pours into the company.
- How slowly the company pays their own vendors. The slower these bills are paid, the more cash the company retains.
- The inventory size and how many times it turns in a year. The larger the inventory, the more cash that needs to be invested to maintain it.
2. Percent of Gross Margin
A big influence on any company's overall profit—and what the owner gets to take home or reinvest—is its gross margin. The difference between sales and cost of goods is known as the gross margin. Many times it is expressed as a percentage of sales. For example, selling a $40 product for $100 gives a gross margin of $60 or 60 percent.
When figuring out the cost of a product, you may want to include everything that is directly related to delivering that product or service. For example, for a service company, it might be the cost of the people with related payroll taxes and benefits. For a toy company, it might be the cost of the product and shipping. You may want to make sure that the gross margin percentage is as high as possible so you can cover other fixed and variable expenses and still maintain a healthy profit at the bottom line. Mathematically, a gross margin of at least 40 to 50 percent may make it easier to achieve this.
3. Variable and Fixed Expenses
Variable expenses can change based on how much product or service is sold in a given month. This can include the cost of inventory, customer shipping and sales commissions.
Fixed expenses stay the same regardless of what is sold in a month (e.g. office rent, utilities and some employees). Keeping as many expenses variable as possible—and only a few expenses fixed—can help companies make a higher profit. Underused resources can become a real drag on the bottom line. This can happen when your employees don't produce at their maximum potential because the pace of the business alternates between very busy and extremely slow. You can try to keep these expenses variable by using seasonal workers, freelancers or other third-party resources and only paying them when they work.
4. Double-Entry Accounting
Double-entry accounting is one of the most fundamental accounting principles around—all financial statements are based on it. It means that each recorded transaction (recording a sale, paying a bill, collecting payments) has equal yet opposite effects in at least two different accounts.
It also enforces the important balance sheet equation of assets equals liabilities plus equity. In double-entry accounting, each transaction is recorded as a debit and credit where a debit in one account is offset by a credit in another account. As a result, the sum of all debits is exactly equal to the sum of all credits. This method can help business owners prepare accurate financial statements and detect errors in the company records. Double-entry accounting can also make it difficult to manipulate financial accounts because it provides a series of checks and balances.
5. Matching Revenue and Expenses
Matching accounting principles state that when a company financially recognizes revenue, they need to also record its related expenses. I recommend never recording sales without logging what the expense is to produce that revenue. For example, when a piano is repaired, you'd record not only what the customer was charged, but the cost of the person to repair the piano plus any new strings or additional supplies.
Finally, outside of tax season, consider asking your accountant to teach you other accounting principles that can help your company at a pace you can understand.
Read more articles on accounting.
The information contained in this article is for generalized informational and educational purposes only and is not designed to substitute for, or replace, a professional opinion about any particular business or situation or judgment about the risks or appropriateness of any financial or business strategy or approach for any specific business or situation. THIS ARTICLE IS NOT A SUBSTITUTE FOR PROFESSIONAL ADVICE. The views and opinions expressed in authored articles on OPEN Forum represent the opinion of their author and do not necessarily represent the views, opinions and/or judgments of American Express Company or any of its affiliates, subsidiaries or divisions (including, without limitation, American Express OPEN). American Express makes no representation as to, and is not responsible for, the accuracy, timeliness, completeness or reliability of any opinion, advice or statement made in this article.