Key Accounting Terms And Basic Financial Ratios For Small Business Owners

December 18, 2015 12:59 am0 commentsViews: 183

By : Dean Bassal

ACCTG1As the owner of a small business, you will often find yourself playing “jack of all trades” – the person responsible for all areas of the company you are running. While many small business owners are able and happy to successfully juggle multiple roles, there are going to be times when you will have to call on the services of other professionals as well.

More often than not, this will take place in the area of your business accounts and taxation matters. There are a number of good reasons why you, as a small business owner, should hire an accounting and tax professional for your business. Very briefly, these include:

Business growth planning – An accountant will be able to help you with developing your business plan, applying for loans, preparing for external audits and even understanding management data and key figures for the purposes of financial projections and reporting.

Saving you time and money – With the daily demands that running a small business entails, the last thing you want is to slip up because you are distracted from trying to do too many things at the same time. Hiring a professional accountant is a great way to delegate the financial side of things so you can focus on the important task at hand – growing your business. In the long run, this will save you time and money.

Financial advice and practical support – Knowing that your business’s finances and bookkeeping are in the capable hands of a professional accountant will leave you better able to grow and develop your small business. There are also advantages to having a professional who understands your business and is able to provide you with up to date financial advice.

All that being said, it doesn’t mean that you can completely wash your hands of all financial matters, as, at the end of the day, it is your business and you need to be on top of everything that’s going on. A good way to do that, at least in terms of your business accounts, is to speak the lingo. By mastering these key accounting terms, you will not only be better equipped to discuss matters with your professional accountant, it will make you a better business owner as well.

1. Profit margins

Unless you can make a surplus between what it will cost you to source the goods or service that you are providing and the income that you will receive from selling this to your customers, you are not going to be profitable. This surplus is what is known as profit marginACCTG2

All small business owners need to know what their profit margin is, and also what is meant by the term gross profit margin. This is the difference between the actual sales price of your product or your service and their actual costs.  Gross profit pertains to the revenue you generate – before you deduct any other operating costs and expenses involved.

2. Operating profit margins

Operating costs refer to any costs that you might incur during your day to day running of the business, such as rent, utilities, salary costs, miscellaneous expenses and so on.

Operating costs, added to your cost of the services or goods sold, are then deducted from the revenue brought in by sales to give you what is known as your operating income figure or profit.

Your profit divided by sales revenue gives you your operating profit margin. The higher your operating profit margin, the better it is for your business.

3. Depreciation and assets

An asset is anything that is owned by the business, from stocks and shares to buildings and equipment, and even patents and copyrights. As a small business owner, it is crucial that you know what your assets are, as well as the different kinds of assets.

Your accountant might speak to you about fixed assets, which refers to non-moving items such as land or an office block, for example. Current assets are items that are more transient, and some simple examples of this would be your cash, receivables and your inventory.

When it comes to assets, an important term that you will need to learn is depreciation. This refers to the drop in value of an asset or resource that is owned by the business due to use, wear and tear, or anything else that would cause it to lose value.

4. Liabilities

A couple of other terms that might come up from time to time when speaking to your accountant are current liabilities or long-term liabilities. These come under the category of obligations that your small business is required to meet.

If they are obligations that the business needs to pay back in under a year, such as credit cards for instance, then they are known as current liabilities. For obligations that the business needs to pay back in over a year, for example the repayment of a business mortgage, then they are known as long-term liabilities.

acctg3Basic financial ratios every small business owner should know

Once you’ve got all the terms down pat, the next thing you need to know is how they all work together. These two financial ratios will help you in the overseeing of your business’ day-to-day money matters, while also providing you with a guide on how well your business is doing. 

Quick ratio

Its name being a reference to the speed in which this formula will tell you whether or not you can get out of your business.  The quick ratio is cash, accounts receivable and any other assets that can be quickly realized divided by your total current liabilities. If your assets are greater than your liabilities, the quick ratio will be greater than one. If it is less than one, your business may not be in a healthy place. If it is more than two, then you have twice the capital that you need and may think about expanding.

Cash flow to debt

Poor cash flow is often cited as one of the main reasons a new business fails. The cash flow to debt ratio is considered the best predictor of business failure.  It is basically your net income plus depreciation divided by your total debt. If the result is less than one, it means you will not be able to cover your bills without additional funding. Anything between one and two means your business is in a good place. And if your total is more than two, it means you have extra capital and should consider expansion or investing the surplus.

As a small business owner, you do not need to be an accounting expert – lots of business owners aren’t – but you certainly do need to understand the ins and outs of your business better than anyone else. Making sure that you have at least a basic understanding of key accounting terms and business financial ratios, including those listed above, will put you in good stead, as they are pertinent to the running (and future growth) of your small business.

 

Dean Bassal is the Managing Director of Bunnett & Bassal Pty Ltd in Dandenong, Victoria, a tax consulting, accounting and financial planning firm that believes in offering competitively priced services and fast, efficient and friendly service. The company has a diverse client base ranging from individuals to small businesses from different industries and cultural backgrounds, all of which make the work even more interesting. For Dean, the most fulfilling part of the job is the relationships that he forms with his clients, and the privilege of seeing them grow over the years. 

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