When you’re starting out in business, it can be hard to make sense of the accounting side of things. How to code transactions and understanding how this drives your accounting system and the financials it provides you. Even people with a lot of experience in business get confused with this because after all you don’t go into business to deal with accounting transactions.
But understanding a few basic accounting principles is absolutely key. Enabling you to keep better data resulting in more accurate financials and the ability to make those important decisions that are key to the success of your business.
Here are a few basic principles that will help you keep your accounting under control which will give you better insights into your business.
What is a chart of accounts and how do I make it work for me?
A chart of accounts is a simple way for your business to categorise every transaction (money movement) that comes in and goes out of your business. In Xero you have a built in chart of accounts made up of accounts that act as categories for all of your transactions (you can tailor this to suit your needs).
These accounts track everything and allow you to get a picture of whats happening with your cash. We can see them in five main categories – Assets, Liabilities, Equity, Income, Expenses and Cost of Sales.
See below for an outline of each:
Assets: Everything your business owns that has a measurable value. This could be office furniture; cars, inventory or invoices that people still owe you money on (Accounts Receivable).
Liabilities: Everything your business owes a measurable amount of money on. This could be a bank loan or purchase invoices that you still owe money on (Accounts Payable).
Equity: This is money that the business owes to its owners, such as money you put into the business, shareholder money and money left over after paying all the bills (earnings).
Income: This is money that has been earned through Sales (also can include interest from bank accounts and other investment sources).
Expenses: This is money that has been spent in the day to day running of your business, such as paying the electricity bill, gas for the car, rent etc.
Cost of Sales: This is used to capture the direct costs relating to your sales. From buying inventory to sell, materials to build your product and so on. For example, if I manufacture and sell handbags the purchase of leather would be a Cost of Sales item.
In accounting, we use the above accounts to accurately record every transaction. This helps you, as business owners, to understand where money is being spent and earned so we can make better decisions on how to manage our business.
How does this help me run my business?
· Understand where your business stands:
Your Balance Sheet will help you understand many things about your business. The first is what you own, what you owe and how much money has been made for the owners (shareholders of the company) – these are called your Assets, Liabilities and Equity in your chart of accounts. Check out your Balance Sheet now in Xero/Reports/Balance Sheet. This will show you all the Assets that the business owns, minus all the Liabilities the business owes, to leave you an amount of Equity, which is money owed to the owners of the business.
Our tip: Create a ratio to measure changes in your business – Debt (Liabilities) to Equity is a useful one (see example below). This will tell you how much your business is financed by debt to others, such as the bank. The greater this becomes the more you will have to keep up with repayments and interest payments on debt which can hurt small businesses.
Here is an example of Debt/Equity Ratio
Suppose a company has a total shareholder value of $200,000 and has $500,000 in Liabilities. Its debt/equity ratio is then its ratio is 2.5 or 250%, indicating that the company has heavily taken on debt and thus high risk. This equation reversed i.e shareholder value being $500,000 and liabilities of $200,000 its debt/equity ratio would be .40 or 40%, indicating that the company has taken on relatively little debt and thus has low risk.
· Understand how profitable your business is:
Our tip: Go searching for information; use the Profit and Loss detail report to understand where your money is being spent and how much of a return is being made. As your cost of sales and expenses increase you should know why – increased turnover, higher supply rates etc. If these aren’t monitored, you could quickly become unprofitable. Run reports over different periods; if your expenses and cost of sales are increasing but your income is not, or you don’t know why there may be some inefficiencies in your business.
Thanks for reading, hopefully this article has allowed you to gain a basic understanding of some the core accounting concepts.