Fundamentals of accounting for small businesses

Small business owners need to build a habit of keeping a record of every income and expense they make in business transactions. It is advisable to contract or hire an accountant from the beginning but many early-stage businesses might not have the resources to do so. In that case, learning the following terminology and regular record keeping is crucial. 

Accounts receivable

Accounts receivable includes money owed by customers as payment for goods or services. A company’s balance sheet will reflect accounts receivable as a creditable asset because there is an understanding that the clients are legally obligated to pay this amount.

For instance, if you sell $10,000 of goods to a company and provide them with a line of credit, and the company promises to repay you in 30 days, you’ll credit your accounts receivable $10,000. Upon receiving payment, you’ll debit $10,000 from accounts receivable and credit $10,000 to your cash accounts.As cash flow came in, you’d debit your cash account and credit your receivables account. Doing so would impact current assets, but it would not impact total assets from a financial accounting perspective.

Assets

Assets are everything that a company owns. In most cases, the company’s assets from an accounting perspective are tangible. Tangible assets include things like equipment, property, cash, tools. Intangible assets, such as stock, copyrights, patents, and trademarks, can also fall under this category.

Bad debt expense

If you make a sale on credit, there’s a chance that you won’t receive payment. This accounts receivable entry on the income statement allows you to write off the money that you did not receive. Marking bad debt expenses can give you a more accurate look at your bottom line. Your cash flow statement will be more accurate, as will your net income.

Balance sheet

A balance sheet is an overview of a company’s financial status, including assets, liabilities, and equity. The accounting equation that you’ll want to keep in mind when it comes to your balance sheet is

Assets = Equity + Liabilities 

A typical balance sheet has three sections: assets, liabilities, and equity. 

Depreciation

Defined as the recovery of an item’s cost over time, depreciation is especially crucial for tax purposes. You can write off and depreciate larger pieces of equipment on your tax returns. Depreciation calls for you to allocate the cost of a tangible asset throughout the entirety of its life, instead of all at once. Depreciation most impacts the cost of long-term assets.

Dividends

Dividends are company earnings that are distributed to shareholders. A corporation’s board of directors typically determines the dividend amounts or percentages. They can be issued as cash, stock market shares, or other property.

Expenses

Expenses are the costs of acquiring something. You can expense everything from raw materials to services. There are typically four types of costs: fixed, variable, accrued, and operational.

Fixed expenses stay consistent from month to month and year to year. Expenses like salaries, rent, and so forth are considered fixed. These costs are not affected by fluctuations in sales, production, inflation, or the market.

Variable expenses are tied to the company’s production. Variable costs can go up or down based on increases and decreases in production or sales. These can change from purchase to purchase. For instance, you may need to buy more materials to complete a large order, which will drive up your variable expenses for the month. These are the total costs associated with bringing a product to the end-user.

Accrued expenses are single accounting expenses that are reported but aren’t yet paid. Operating expenses are costs that are necessary for a company to conduct business. These are the costs not directly associated with producing goods or services. For instance, the rent that you pay for an office building is not an operating expense.

Fiscal year

A fiscal year is the measured period of time that a company uses for accounting purposes. The fiscal year can coincide with the calendar year, but it doesn’t necessarily have to. For example, fiscal years can run from October to September or July to June. The company is responsible for choosing the fiscal year start and end dates.

Forecasting

Forecasting is the process of using a company’s historical financial data to predict future business trends. Businesses typically use it to estimate budgets for a specific period, but they can also use it to predict things like sales, gross profits, the value of an asset, or how long it will take to pay off long-term debt. Forecasts often include supply and demand figures, sales records, and expenses.

General ledger

This is the complete recording of a company’s financial transactions over the lifetime of the organization. The ledger tracks the owner’s capital, assets, revenues, and expenses. Business owners must be diligent when recording transactions in the general ledger.

Generally accepted accounting principles (GAAP)

Generally accepted accounting principles are the rules, standards, and principles that certified public accountants and businesses use when accounting. These principles are a combination of authoritative standards and accepted practices. Failing to follow GAAP could prove troublesome for businesses because it can make it harder to secure funds from investors and potentially expose owners to federal fines.

Journals

Journals are also referred to as accounts. This is where transactions are recorded as they occur and before they are transferred to the official accounting record, or the general ledger. While the general ledger records broader things like liabilities, things like accounts payable would show up in the journal.

Liabilities

Liabilities are debts that a company is responsible for paying in the short or long term. Things like mortgages and credit card balances are liabilities.

Market value

Market value is a measure of how much investors think a firm is worth. Looking at financial documents is an excellent way to measure market value. But market value can also account for intangible things, like intellectual property. For example, if your business plan includes a revolutionary idea but you haven’t started selling goods yet, your market value could be high even though your net income is low.

Profit and loss statement

Commonly referred to as “P&L,” or the “income statement,” a profit and loss statement is a report that lists earnings, expenses, and net profits for a given period.

Revenue

Revenue is the total amount of money collected for goods or services sold before subtracting any expenses. It also includes any credits or discounts for returned merchandise.

Trial balance

Trial balance is an exercise used to confirm final figures before generating financial statements. It requires placing debits and credits on a worksheet to ensure that any current balances are correct. Accounting software can perform trial balances automatically.

Working capital

Working capital is the amount of money a company has to invest or spend on necessary items for the business. Essentially, it’s a measure of operating liquidity and can help business owners determine how much they can allocate toward operating expenses. If you combine working capital with fixed assets, like office buildings or equipment, you will have “operating capital.” Capital is different from net worth, which also accounts for assets like buildings and equipment. 

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Banking options for startups and small business owners

Small businesses banking sectors are very competitive these days. As an early-stage business owner, it is important for you to shop around, and make sure you sign up for a plan that fits your business’s needs. If you choose to opt for a business loan through a financial institution, going with the same institution for your banking needs might be the best option, though it is not necessary. 

The Best Small Business Bank Accounts in Canada provides a comparative analysis of different small business bank accounts with low volume transactions. 

When setting up your business bank account you will require your Master Business License, business number, valid piece of ID and initial fee for the account. 

Managing Cash flow

“Cash flow” is a term that refers to how cash moves in and out of your business and your bank account. Cash inflows are your sources of income, and cash outflows are your business expenses. Naturally, positive cash flow is better than negative cash flow.

Step 1: Understand the current scenario of your business by running a profit and loss statement for the last three months. Based on the peaks and troughs, populate the forecasting templates taking into account as many “what if” scenarios as possible. 

Step 2: After analysing, the next step is to identify areas where you can maximize cash ins and minimize cash outs. An example could be asking your clients to clear their dues by sending a timely invoice with clear payment terms and identifying monthly payments that could be covered through subsidies or loans. 

Financing for small businesses

Before you start raising money for your business, make sure you have a good credit history, strong business plan and some collateral. You can also create a personal balance sheet to understand your personal assets and liabilities. 

1. Bootstrapping -Bootstrapping is building a company from the ground up with nothing but personal savings and operating revenues. 
2. Pre-selling- Pre-sell your products to your customers. You can use platforms like Kickstarter to start your pre-selling campaign. You can also use your website/social channels to pre-sell your products/services. 
3. Line of Credit (LOC)– A LOC is an arrangement between a financial institution—usually a bank—and a client that establishes the maximum loan amount the customer can borrow. The borrower can access funds from the line of credit at any time as long as they do not exceed the maximum amount(credit limit) set in the agreement and meet any other requirements, such as making timely minimum payments.
4. Venture capital (VC) – Venture capital firms are professional, institutional managers of risk capital that enable and support the most innovative and promising startups that could not be financed with traditional bank financing. Venture capitalists usually make equity investments in companies.
5. Angel Investing -An angel investor (also known as a private investor, seed investor or angel funder) is a high-networth individual who provides financial backing for startups, typically in exchange for ownership equity in the company. Often, angel investors are found among an entrepreneur’s family and friends. The funds that angel investors provide may be a one-time investment to help the business get off the ground or an ongoing injection to support and carry the company through its difficult early stages.
6. Grants and subsidies– A grant is financial assistance given by a government, organization, or person for a specific purpose. Unlike a loan, you do not have to pay back the money. 
7. Crowdfunding– Crowdfunding is the use of small amounts of capital from a large number of individuals to finance a new business venture. Crowdfunding makes use of the easy accessibility of vast networks of people through social media and crowdfunding websites to bring investors and entrepreneurs together, with the potential to increase entrepreneurship by expanding the pool of investors beyond the traditional circle of owners, relatives, and venture capitalists.
8. Business Incubators/Accelerators– Business Incubators are facilities that share their resources, expertise and logistical support with early stage companies usually specializing in state-of-the-art sectors like high-tech, machine learning, SAAS, biotechnology, etc. The expectation is that the company will be moving out of the incubator once it reaches a stable stage. These incubators also have access to mentors, advisors, and funding that make them a great option for new entrepreneurs. Find a list of Canadian incubators and accelerators here- CAIN. 
9. Debt Financing – To qualify for a loan, you will need a good credit score, collateral, some investment, and a business plan. 
   1. Canada Small Business Financing Loan– Small businesses looking to purchase or improve their assets for new or expanded operations can benefit from the Canada Small Business Financing Loan (CSBFL). This loan is a government-sponsored loan program in partnership with financial institutions that offers up to $1,000,000 ($350,000 for equipment and leasehold improvements) to small businesses in Canada. CSBFL usually finances the cost of:
      1. purchasing or improving land and buildings used for commercial purposes
      2. purchasing new or existing renovations to premises occupied by the business as a tenant
      3. purchasing or improving new or used equipment (including commercial vehicles)
      4. Term Loans: 
      5. Operating Loans: 
      6. Shareholder Loans 
   2. Friends and family Loan– Asking friends and family for a loan is a usual first step when startups begin fundraising. This is the easiest way to get initial financing, but it can cause tension or strain in the relationships in case things go south. It is wise to sign an agreement beforehand to avoid conflicts and delays. 

Equity investments – An equity investment is money that is invested in a company by purchasing shares of that company in the stock market. These shares are typically traded on a stock exchange.

Templates

• Cash Flow Statement 
• Cash Flow Forecasting 
•  Business Loan Calculator
• Debt to asset ratio
•  Return on Investment
• Debt to Equity Ratio
• Balance Sheet
• Income statement

References

Quickbooks Resources- https://quickbooks.intuit.com/r/starting-up/

Investopedia- https://www.investopedia.com/financial-term-dictionary-4769738