11 Accounting Terms Every Small Business Owners Should Know

As owner of a small business, it is very important for you to have a basic understanding of some simple accounting terms. Seem strange because you already hired an accountant? But knowing some business accounting key terms to some extent will make you a much more versatile business owner.

You don’t have to be totally fluent in accounting terminologies because your accountant or bookkeeper will explain the financial position of your business in plain English. But, that said, you’ll be able to go a lot deeper if you know some accounting terms to get in the weeds on specifics.

For instance, if you are traveling to a foreign country. If you went to London and didn’t speak English, you would want to have a few phrases handy before you got there, right? In that same manner, it will be wise to understand some basic terms in accounting for small business before meeting with your financial advisors. You will lose nothing in translation, making your meetings to be productive, efficient and enjoyable.

We compiled a list of accounting terms every small business owners should know.

1: ACCOUNTS RECEIVABLE AND ACCOUNTS PAYABLE
Accounts receivable simply means money owed to you. Accounts payable on the other hand means money you owe to others. Seems simple enough right? But these two terms are often difficult for small business owners. Do you ask for accounts payable or accounts receivable when you need to speak to a customer about a payment owed to you? How about when you need to discuss a bill you owe to a vendor?

The easiest way to understand these two key accounting terms is to remember that one man’s payable is another man’s receivable. If you are calling a client about money owed to you (your accounts receivable), you need to speak with with their accounts payable department. Similarly, if you’re calling one of your vendors to negotiate terms on an invoice (your accounts payable), you need to speak with their accounts receivable department.

Keeping this simple rule in mind will save you valuable time when communicating with your customers and vendors… it will also save you from the embarrassment of asking for the wrong department.

2: BURN RATE
This is an important small business accounting term. The burn rate of your business is the rate at which your business spends money. You need to know this term as a small business owner.

It is very easy to calculate the burn rate of your business: All you have to do is pick a time period—usually a quarter or longer, then subtract the cash on hand at the end of the period from the cash on hand at the beginning of the period, then you divide the result by the number of months in the period, the answer is your burn rate.

For example, assuming say you had $12,000 in the bank at the beginning of the quarter, and your bank balance reduced to $6,000 at the end of the quarter after some expenses. When you subtract $12,000 from $6,000, the answer is $6,000. This means you spent $6,000 over the three month period. Then you divide $6,000 by 3 months, your burn rate is $2,000 per month.

In cash flow management, knowing how fast your business spend cash is vital. Every business wants to have a negative burn rate, because it shows that you are growing your cash reserves. This rule is excepted from when you are investing in the growth of your business.

3: CHART OF ACCOUNTS
Chart of accounts (COA) is like a filing cabinet for all financial transactions of your business. It is referred to as a complete and comprehensive listing of every account in your bookkeeping system. 

The chart of accounts helps to keep the data in the general ledger (we will discuss about it below) organized to make your financial reports meaningful. Business owners should work closely with their accountant or bookkeeper to maintain the chart of accounts.

4: COST OF GOODS SOLD
Cost of goods sold is one of the most important business accounting terms. The cost of goods sold (COGS) or cost of sales (COS) of your business is the direct cost of producing your product or delivering your service. The COGS or COS is an important step in determining your gross profit margin. 

For instance, let us assume that the income of your business over the course of the year is $1 million. Sounds pretty impressive, right? But what if your cost of goods sold is $900,000? This means your $1 million business only had $100,000 after paying for the production of your product. Your gross profit margin is just 10%. 

COGS or COS is the first expense you will see on your income statement. Reducing this expense will automatically let you increase your overall profit even without increase in sales.

5: DRAWS AND DISTRIBUTIONS
Although it depends on how your business is organized, some small business owners might or might not be on their company’s payroll. However, most of them take at least a portion of their pay in the form of draws or distributions depending on how the business is structured.

It is very important to note that draws and distributions do not appear on the profit and loss statement (income statement). They are reduction in the equity (see below) of the business, so they appear as subtractions in the equity section of company's balance sheet.

6: EQUITY
Equity is your ownership in the business. It’s a combination of the money and other things of value you’ve invested in the business plus the earnings the business has retained over its lifetime. Equity is also the difference between the business’s assets and its liabilities.

Many small businesses have negative equity in reality. Negative equity is an indication that the owner is drawing too much cash from the business for private use, debt is too high, or that the business is not making profit. Should you decide to sell your business, a healthy equity is among other things attractive to potential business lenders, Investors and buyers.

7: GAAP
GAAP is the acronym for generally accepted accounting principles, which are the guidelines for proper accounting and financial reporting. GAAP compliance is particularly important in publicly traded companies, but many lenders and investors require GAAP-compliant reports as part of their decision-making process. 

A good bookkeeper or accountant should make sure your financial statements are GAAP compliant even if you don't own a publicly traded company or your buy aren’t seeking funding.

8: GENERAL LEDGER
The general ledger is very important to your business, it is the basis for your entire bookkeeping system. It can be defined as a history of all record of all the financial transactions in your business. The general ledger of a business is organized by the chart of accounts (see above). 

It is important to Keep a backup of your general ledger. In the event of a disaster e.g fire Outbreak, water, theft, misplaced, etc your accountant or bookkeeper can help you prepare the financial statement of your business using the data in the backup of your general ledger.

9: LIABILITY
Liability in accounting can be defined as a debt your business owes. This could be in form of a credit card balance, a loan, taxes, overdraft, etc.

Liability is a balance sheet item i.e it appears on the balance sheet not in the income statement. They are paid over a period of time, either short term or long term by reducing the cash in your business checking account and this also reduce the amount due on the liability. 

Liabilities are not bad, they are inevitable in business. But it is necessary to make sure your assets (what your business owns) are greater than your liabilities (what your business owes). Otherwise it will have a negative impact on your equity, and you could find yourself in a dangerous position if you experience a decrease in sales or need financing to expand your business.

10: PROFIT
Profit making is the sole aim of any business organization. The profit ascertained on your profit and loss statement is almost not a representation of the cash you have in your bank account.

In business bookkeeping and accounting terms, net profit is the difference between income, cost of goods sold, and the operating expenses in the business, as well as interest expenses and depreciation. You must remember that there are certain cash flow activities like draws and distributions and debt payments which don’t appear on the profit and loss statement. 

11: RETURN ON INVESTMENT
Return on investment often called ROI is an analysis of financial performance in relation to money or time invested in the business. 

For instance, let’s assume you spend $900 on a sales training program. The sales in your business was able to increase by $9,000 as a result of this training. The gross return on your investment is $8,100 ($9,000 in sales, less the $900 you spent on the training program). Your percentage ROI, though, is 900% (the $8,100 gross return divided by the $900 you invested on the sales training program).

Always take note of the ROI on your major investments of time and money to be sure you are focusing your resources on the most profitable activities in your business.