Fancy Financial Terms You Should Probably Know
We get that not everyone is a lover of numbers or financial data. But at Eide Bailly LLP, we do believe you should have a basic foundation of financial literacy in order to run a business. So we’ve made you a glossary of common financial terms you’ll often encounter (and that your accountant will probably use in every day conversation). Here’s to a better understanding of the numbers!
Accounting entry representing the money owed by you to vendors
Money owed to you by customers or employees
A method to track your financial data. In essence, an accounting system is a hierarchy of data. It takes every day transactions of your business, organizes it into a general ledger and converts it into meaningful data so you can make informed business decisions. These systems can be manual or computerized (let’s be honest, computerized is much more efficient).
“Stuff” you own or is owed to you, including cash, inventory, receivables and equipment.
Current Assets: What you own that you expect to turn into cash or consume within a year.
Fixed Assets: Property and equipment purchases for use that exceed a year and therefore tend to be more permanent. Think leasehold improvements, furniture and fixtures.
Intangible Assets: Assets you can’t see or touch, but that you paid money for and have value. Think franchise rights, trademarks or patents.
Long-Term Assets: Assets you expect to be consumed during a timeframe that extends longer than a year.
Tangible Assets: Assets with a physical form. Think machinery, inventory, buildings, etc.
Basis of Accounting
A set of rules (or principles) that help you determine when and how a transaction should be recognized (recorded). There are several different frameworks, but two of the most common are:
Accrual Basis Accounting: Revenues and expenses are recorded when earned (regardless of when cash is received) and incurred (regardless of when they are paid). This is also commonly referred to as generally accepted accounting principles (GAAP); in the United States of course.
Cash Basis Accounting: Revenues are recorded when cash is actually received and in hand, while expenses are recognized when cash is actually paid out. There are two different methods of cash basis accounting: pure and modified. The main difference is under the modified cash basis some transactions follow accrual basis accounting.
Income Tax Basis: Recording of revenues and expenses depends on the tax regulations; eliminates the need for converting from one basis of accounting for recordkeeping to another for tax return purposes. That may seem like a time saver but income tax basis is not always the best measure of operational performance.
Regulatory: Recording of revenues and expenses depends on the regulatory agency prescribing the method. Government agencies commonly have a regulatory method of accounting that must be followed.
Learn more about the difference between accrual and cash here.
Projections of cash inflow and outflow within a given timeframe. Think of it like a forecast of what your check book will look like in the future
Cash coming in versus cash going out. It’s the difference between the cash at the beginning of the period and at the end of the period. It’s pretty straightforward … if you have more cash coming in than going out, you have positive cash flow. If you have more going out than coming in, you have negative cash flow.
Note, this is not the same thing as profitability.
How much cash the business has (or how much it is short) for a given period.
Chart of Accounts
The “table of contents” for your general ledger. Typically, the chart of accounts is structured as follows (or something close to that):
5000-5999 Cost of Goods Sold
6000-6999 Operating Expenses
7000-7999 Other Income and Expense
8000-8999 Income Tax Expense
The number of individual accounts within each account type (assets, liabilities, etc.) will depend on the needs of your business. Generally, chart of accounts are set-up with the least number of accounts to achieve the financial information needed and are structured for growth.
A compilation consists of obtaining a trial balance, formatting and grouping accounts for correct financial presentation in accordance with the appropriate basis of accounting, typically generally accepted accounting principles. A compilation does not include an opinion or any other assurance from the auditor on the accuracy of the accounting records.
Equity put into the business such as cash infusion or personal assets that will be converted to business assets.
Cost of Goods Sold (COGS)
The expenses incurred directly related to the sales. It includes the full cycle of the good or product, from the cost of buying raw materials through production of the finished product. For example, the purchase price of inventory sold or labor and materials in a manufacturing process to produce the products sold. (The products not sold are inventory.)
Amount of money lent from one party to another. Businesses use debt as a way to make larger purchases or expand their business, normally with terms regarding repayment within a certain timeframe and with interest.
Financial Gap: The amount of new debt or equity you’ll need to borrow to support increased sales. This is calculated as the difference between the funds needed to buy new assets and the funds currently available.
Leverage: The amount of debt used to finance a business’s assets. If you have a larger portion of debt than equity, your business is considered highly leveraged.
Long-Term Financing: Money owed to banks or other creditors that is due outside of a year.
Short-Term Financing: Debt to be repaid within one year
How much of an asset’s value has been used up in the course of its useful life. There are various methods of depreciation. The following are methods of book deprecation:
Straight Line (most common): A method in which depreciation is recognized evenly over the useful life. Depreciation is calculated by multiplying the original cost less salvage value by the straight line rate. The straight line rate is calculated by dividing 1 by the useful life. For example, the straight line rate of a 5 year asset is 20% (1/5).
Double Declining: An accelerated method in which more depreciation is recognized in the earlier years of the life of an asset. Depreciation is calculated by multiplying the net book value (original cost less accumulated depreciation) each year by 2x the straight line rate (see above). For example, the double declining rate of a 5 year asset is 40% ((1/5) x 2).
Units of Production: An activity based method in which depreciation is recognized as it is physically used. Depreciation is calculated by multiplying the actual production (or use) by a production (or usage) rate. The production (or usage) rate is calculated by dividing the original cost less salvage value by the total expected production (or usage). For example, the production rate of a $7,500 asset with expected production of 15,000 units is $0.50.
Sum of the Years Digits: An accelerated method in which more depreciation is recognized in the earlier years of the life of an asset. Depreciation is calculated by multiplying the original cost less salvage value number of useful lives remaining divided by the sum of the years. For example, a 5 year asset would be depreciated as follows:
Y1 5/15, Y2: 4/15, Y3: 3/15, Y4: 2/15, Y1: 1/15 (1+2+3+4+5 = 15)
Equity taken out of the business such as a draw, inventory for personal use or personal expenses paid on behalf of the shareholder(s).
The business worth (ASSETS – LIABILITIES). Equity is often comprised of, but not limited to, common stock, paid in capital, contributions/distributions and retained earnings.
Financing Activities (in the Statement of Cash Flows)
These relate to activities surrounding debt and lines of credit, including, but not limited to, cash payments on long-term debt, cash received from issuance of long-term debt, cash received and paid on a line of credits and cash contributions or distributions from an owner.
Where transactions are being tracked. Think of it like a hypothetical filing cabinet. It includes various accounts that organize transactions into like categories.
The amount paid prior to deductions being taken, including overhead, payroll, taxes, etc.
The raw materials, work-in-process and completed goods that are ready (or will be ready) for sale. These are considered part of the business’s assets.
Investing Activities (in the Statement of Cash Flows)
These include, but are not limited to, cash payments to purchase investments and fixed assets such as property or equipment. They also include the cash received for selling an investment (as well as a dividend from an investment) and fixed assets.
Documentation of a commercial transaction between a buyer and a seller.
“Stuff” you owe to others, like creditors that must be repaid. For example, accounts payable, credit cards payable, sales and payroll taxes are all liabilities.
Accrued Liabilities: expenses you incurred but have not yet paid for, such as sales tax and payroll. We’re talking here about wages, withholdings and taxes.
Current Liabilities: debts that must be repaid within a year, including short-term notes payable.
Variable Liability: Liability that fluctuates to support payment of variable assets.
The outstanding amount following deductions being taken.
How much a company’s, or individual’s, assets surpass their liabilities. High net worth is a good indicator of solid financial health.
Operating Activities (in the Statement of Cash Flows)
Company’s day-to-day activities that largely determine the profitability of the company. These are the core business activities that directly impact income because they provide the majority of your cash flow. Cash flows from operating activities typically results from the changes in trade accounts receivable, accounts payable, inventory, etc.
The normal, ongoing cost of operating your business. These expenses are incurred whether you sell your products/services or not. Think office wages, professional fees, office supplies, bank fees and advertising.
Calculations that let you know how you are doing compared to historical performance or industry benchmarks.
When the amount of revenue gained from the business activity, product or service exceeds the expenses from that activity. In other words, it’s what’s left after deducting all of the business expenses from income generated.
Gross Profit: SALES – COST OF GOODS SOLD. This is also known as gross margin.
Net Profit: GROSS MARGINS – OPERATING EXPENSES + OTHER INCOME/EXPENSES. Also known as the amount remaining after you’ve met all your expenses.
Meaningful data compiled from the information in the general ledger. There are two basic reports: balance sheet and income statement (aka profit/loss statement and statement of operations).
Balance Sheet: Statement of financial position that gives you the assets, liabilities and net worth of the business. In other words, it measures a company’s resources. Typically, it’s configured this way:
ASSETS = LIABILITIES +EQUITY
Income Statement: Summary of revenue, costs and expenses for an organization. Also known as the profit and loss statement, it measures the business profitability. Typically, it’s configured this way:
SALES – COSTS OF GOODS SOLD = GROSS MARGIN
GROSS MARGIN – OPERATING EXPENSES + OTHER INCOME/EXPENSES = NET INCOME
Statement of Cash Flows: Statement of sources and uses of cash. It is broken into three sections: operating activities, financing activities and investing activities.
Percentage of net earnings not paid as distributions (it’s the accumulation of net income and losses over the life of the business plus or minus owner contributions or distributions, respectively). Instead this amount is used by the company to be reinvested in the business, or to pay back debt. It’s also known as shareholders’ equity.
A review not only includes the work contained in a compilation, but it also includes analytical procedures performed on certain accounts within your company financial statements and inquiries made of those within your company. In other words, a review includes things like analyzing your revenues and expenses, gross margins and key metrics related to things like accounts payable and fixed assets. While there is limited assurance given in a review, there is still no full blown opinion issued.
Gross proceeds (amount received prior to debits for production) from the sale of a product or service. In other words, it’s the amount of money you make from a sale before payments related to production of the product are taken out.
How quickly (or not so much) a company can grow while maintaining its target debt-to-worth ratio.
An event in the business finances that must be recorded in the books.
Cash transaction: a transaction that is settled with cash on the day of the deal.
Non-cash transaction: settling a deal without cash. Think seller financed property and equipment, trade for goods or services and depreciation. These can be done through bartering or trade for other goods or services.