As an entrepreneur, it’s essential to know the ins and outs of your business and to be the expert on your product or service. But when you break it all down, do you really understand the business side of things? If you don’t understand the basics of your reports and what the numbers are really telling you, it’s ok to take a step back.
Take the time to simplify things, understand what the KPIs, reports, and numbers really tell you about your company’s financial situation. Even more importantly, make sure you know how to leverage all the data you’re collecting in your books. Below are some of the most common accounting terms and reports that every business owner should understand.
Gross Margin
Gross margin is the amount of money your company keeps after paying all direct costs associated with producing the product or cost of goods sold (COGS) are subtracted. Gross margin is expressed as a percentage (total revenue – COGS) / total revenue x 100.
Gross margin averages vary widely depending on the industry and maturity of the business. Analyzing the company’s gross margin offers an opportunity to identify areas to reduce costs or increase prices if necessary. If a company has a gross margin of 40%, that means that they are retaining $0.40 for every dollar of sales. The other $0.60 is spent on direct costs, such as labor or supplies. A low gross margin could mean the need to source lower-cost materials or increase the retail price.
Net Income
Net income is the amount of money your company earns after paying all of its expenses. To determine the net income, subtract all expenses from all revenue. This means subtracting both cost of goods sold and operating expenses, along with salaries, interest paid on debt, and anything else the company pays for. You can find the net income amount at the bottom of an income statement, which is where we get the expression “the bottom line.”
If you ever find the need to raise capital, net income is what investors will evaluate to determine the company’s overall profitability.
Income Statement
The income statement is a financial document that reports revenue, expenses, gains, losses, and net income during a set period of time. You may also hear it referred to as a statement of operations or the profit and loss (P&L) statement. Net income is calculated by (revenue + gains) – (expenses + losses).
The income statement is one of the most important financial documents to monitor for overall financial health, along with the balance sheet and the statement of cash flow. The income statement is used by stakeholders and potential investors to get an idea of the overall financial health and profitability of a company. It can also be a great tool to help you compare the financial performance of different sectors of the company.
As a business owner, you should review your income statement regularly. Having all of your bookkeeping stored in the cloud can make the process simple and quick, giving you access to your income statement and other reports updated with real-time financial data.
Operating Cash Flow (OCF)
Operating cash flow (OCF) consists of the amount of cash left over after operating expenses have been subtracted. It’s crucial for business owners to be aware of OCF to determine if the company can generate sufficient cash flow in order to maintain operations or expand. If a company fails to maintain positive OCF, they may need to raise outside capital, along with evaluating expenses.
Accounts Receivable (AR)
Accounts receivable (AR) refers to the amount of money your customers or clients owe to you for the goods or services your business provides. Accounts receivable are legally enforceable claims and are recorded as current assets on your balance sheet. When you send an invoice, the money you’re owed falls under accounts receivable until the customer pays the bill. At that point, the amount moves out of receivables and into cash.
Accounts receivable should be evaluated yearly to determine how often the money is collected, (sometimes known as accounts receivable turnover ratio). If a company has a poor ratio, it might need to re-evaluate the collection process or collection time to ensure collection from customers.
Accounts Payable (AP)
Accounts payable (AP) is the opposite of accounts receivable—it’s the money your business owes creditors or suppliers. You can think of your AP as the bills you pay for your business. Accounts payable are considered a liability on your balance sheet. When recording AP (e.g. paying a bill), you should credit AP and debit the appropriate expense account. Once you have paid the invoice, you credit the cash account and debit the AP account.
This is also another vital area investors will examine if you find the company needing to raise capital. AP shows how much the company owes and should always be within reason for your AR. If AP is too high, it could raise a red flag with investors and lenders. To simplify your AP processes, we recommend Bill.com because it allows business owners to manage the approval process and pay business bills on time.
Whether you’re just starting your business or expanding your current operation, cloud-based accounting systems can allow you to quickly pull reports, giving you a real-time picture into your business’s financial situation. When you have the basic understanding of what the reports are telling you, the guessing game is replaced by strategic informed business decisions. Our cloud specialists can help you choose the right apps for your business.
It’s always a good time to refresh your basic bookkeeping skills and make sure you’re familiar with common accounting terms. We created our 5 Weeks to Better Bookkeeping online course to help you understand your business finances. The course is free for small business owners and includes videos, downloadable cheat sheets, and step-by-step guidance. Follow the link to learn more and sign up now.