5 Accounting Terms Every Small Business Owners must Know

According to Warren Buffett, the world’s richest investor “accounting is the language of business” and I believe it is the truth in its entirety. There are several accounting terms that entrepreneurs and managers must understand to run a business successfully but below are five of these business metrics. If you are ready, then let’s proceed.

1. Cash Flow

The most important aspect of any business is cash flow.  Even a profitable business with great margins, booming sales, an innovative product and healthy balances in inventory and accounts receivable can fail if it can’t access the cash necessary to maintain day to day operations.  Keeping an eye on cash flow is one of the most important aspects of any small business manager’s duties.  Some key concepts of cash flow to keep in mind are:

  • When credit is extended to customers on sales, cash receipts will lag behind actual sales
  • A small increase in accounts receivable may have a significantly negative impact on cash reserves
  • Customers will generally delay payment as long as they’re able to in order to leverage their own cash

If a business is suffering from cash flow issues, but all of its other metrics are healthy, managers could consider some of the following measures to shore up cash reserves and avoid cash flow deficiencies in the future:

  • Apply better inventory management – inventory can tie up a significant portion of a company’s cash reserves
  • Offer discounts to customers who pay in full within a certain period of time – if cash is low, keeping enough cash to keep the business going may be a higher priority than collecting slightly more revenue down the road.
  • Look for ways to leverage credit when purchasing – buying inventory with credit terms or paying major capital expenditures in installments can free up precious cash

2. Gross Margins

The gross margin of a business (sales minus direct costs) is the amount of money remaining after the costs directly associated with the sale of the product – e.g. production labor, raw materials, shipping – are accounted for.  This number directly impacts the ability of a small business to earn a profit; therefore, properly managing gross margins is one of the keys to ensuring that a business can reach profitability.

For example, a bakery can approach its production capacity, but still not generate a profit if its pricing is so low that it does not generate enough income to cover its fixed expenses.  Without understanding gross margin and being able to identify low gross margins as the problem, the hypothetical bakery owner might make poor decisions to compensate for the business’ losses, such as lowering prices to increase its ability to compete with other businesses.

Managing gross margins can be tricky, as the business owner has to constantly keep the competition in mind when managing pricing. However knowing the exact gross margin on each sale is crucial to the operation of a small business.

3. Days Sales Outstanding

If cash flow is king, then it stands to follow that managing accounts receivables is a vital aspect of running a small business. Days Sales Outstanding, or DSO, is the number of days that it takes a company to collect cash after a sale is made. A high DSO means it takes the company longer to collect on its accounts receivable. DSO is calculated by dividing accounts receivable by total credit sales and multiplying by the number of days it takes to collect.

DSO is important because of its significant effect on cash flow. A lower DSO means the company has more opportunity to reinvest the funds to grow the company. For company’s facing cash flow problems, lowering the DSO may even be essential to survival.

4. Sales

No business on earth can survive without sales. Even technology startups that rely on free user acquisition to gain market share must eventually be acquired by a company that can leverage their users into sales. A business can have a high gross margin and low fixed costs, but without sales, it is doomed to fail.

5. Tax Liability

Every small business owner must be fully aware of the tax obligations that come with operating a business. From federal taxes, to state taxes, to local Govt taxes, failing to keep track of your business’s tax liability can severely dent a company’s financial picture.

Although small businesses may not have as much room to maneuver around taxes as larger companies, structuring a small business to minimize tax liability can be crucial to a company’s success.  Through proper planning, selecting the right legal structure, making the right deductions, and proper tax return preparation, small businesses can minimize their tax liabilities and ensure that there are no unpleasant surprises from the revenue that could cripple the business.

For your free accounting consultation, don’t hesitate to consult us for free advice.

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