3 Financial Accounting Concepts Every New Entrepreneur and Small Business Owner Should Know

It is no secret the new entrepreneurs and small-business owners need to wear a lot of hats. While they don't need to be a CPA, there's some key accounting concepts that should be at the back of their mind while operating their business. By keeping these concepts in mind while operating the business, the owner and have a better view of the business and be more prepared with respect to the financial and accounting aspects of their operation.

In this series we're going to look at three different areas of accounting and what small business owners and entrepreneurs can learn from each area.

The first of these three areas is financial accounting. Financial accounting is the branch of accounting that keeps track of a company’s financial transactions and reports on historical periods. Owners, lenders, and investors use this information to get a picture of how a business is doing and make critical decisions on what to do next with the operation as a whole.

Key Financial Accounting Concept #1: The Different Types of Accounts

• In order to truly understand how a business works, you need to be able to read the financial statements. process of reading and understanding the financial statements starts with understanding the basic types of accounts. They are: assets, liabilities, equity, revenues, and expenses. See below for a brief explanation and example of each of these accounts.

  • Assets – Resources owned by the Company.

  • Liabilities – Obligations of the Company.

  • Equity – What is left over when the Company uses its assets to pay off liabilities

  • Revenues – Amount of inflows generated from the sales of goods and services during the current reporting period.

  • Expenses - Amount of outflows generated from operating the company during the current reporting period.

Key Financial Accounting Concept #2: The Accrual Basis of Accounting

Many people understand accounting at a basic level where cash can be exchanged for goods and services and those transactions are recorded on the books of the business. What is less intuitive for those not as familiar with accounting is the aspect of an accrual basis where assets and liabilities can be recorded before or after cash is received. Have you ever heard of an accounts payable or an accounts receivable department? Those are the result of accrual basis accounting. For smaller businesses, accrual accounting can be described as recording expenses when they are incurred, and not when they are paid. If your business receives an invoice for goods purchased in the last two weeks but you can't pay it until next month there should be a liability recorded on the books to reflect the fact that you owe somebody money (accounts payable). The same concept can be applied to revenue and receiving money (accounts receivable).

If you are ever thinking of getting a small business loan or line of credit from a bank it's very likely that they will require accrual-basis financial statements for the business; so it's best to get started on setting up your company on the accrual basis of accounting as soon as possible.

Key Financial Accounting Concept #3: Working Capital

Lenders and analysts will look at a company to see if it's worth investing in based off of financial and some nonfinancial metrics. Of the many financial ratios that are used to evaluate the short-term and long-term health of a company, we feel the most applicable one to small and growing businesses is the concept of working capital. Working capital is the difference between a company's current assets and current liabilities and measures the liquidity of the operation in the short term. Companies should aim to have positive working capital whenever possible, but should be careful not to hold too much cash when it could be reinvested back into the company for a positive return.

There you have it! Three key things from financial accounting that new entrepreneurs and small business owners should know. While this is not an exhaustive list of the basic concepts, or a complete course on all financial accounting concepts needed to run a business, it’s an excellent baseline to get you started as a starting small business owner or entrepreneur. Do you have any questions for us? Please let us know by contacting us using the contact tab. Stay tuned for our next entry in the series where we will go over managerial accounting concepts. You won’t want to miss it!