Have you ever sat in a meeting with your accountant and they are discussing certain terms to and you had no clue what they were talking about? Unless you are an accountant or possibly a bookkeeper, you probably are confused on what they are talking about. You may be aware of some accounting terms such as accounts receivable, accounts payable, profit and loss, balance sheet, etc. But there are some other common accounting terms that will have you sitting there scratching your head on what your accountant is taking about. Your accountant should be explaining to you what they mean/are, but if they don’t or you do not use an accountant, you should be aware of what these terms mean and how they impact your business.
The first accounting term that you should be aware of is burn rate. The burn rate is simply a measurement of negative cash flow (quoted usually as cash spent per month) or the rate your new company is spending, using its venture capital in order to finance overhead before the business has generated positive cash flow from operations. This term is usually used by startups and investors as a means to track how much money the company spends before it begins to generate its own income. The burn rate can also be used as a measurement for your company’s runway or the amount of time your company has before it runs out of money. This is important for you to know as it will help you better understand how your accountant helps you manage your cash flows.
Another common accounting term small businesses should know is chart of accounts. Your business’s chart of accounts (COA) is essentially a listing of all of your company’s accounts in one place. This account will include revenue, expenses, assets, liabilities, and equity and the COA will differ from industry to industry. As a business owner, knowing about the chart of accounts will help give you a rough idea of your company’s financial health. The chart of accounts also helps to keep the data of your company in the general ledger.
Draws and distributions is another accounting term that you may not be too familiar with. Each business is different, with some business owners being on their company’s payroll and others not being on the payroll. Majority of small business owners will take some of their pay, or in some cases all of their pay, in the form of draws and distributions. The payouts from draws and distributions will not be found on the profit and loss statement, since the payouts are a reduction in the equity of the business and will show in the subtractions in the equity section of the balance sheet. Draws and distributions are just a way for owners to periodically take money out of the business to pay themselves and a way for them to take out extra cash from the business. Draws and distributions will only work for business entities that are considered pass-through entities, with the business owner being taxed individually on their business ownership rather than the business entity being taxed like in non-pass through entities. With draws and distributions being money just taken from the business to the owner, who are seen as the same entity, there is no income tax consequences for the owner.
Retained earnings is a term that many business owners have heard of, but not quite sure of the definition. Retained earnings is just the amount of net income left over from after the company payouts in t dividends to the shareholders. Retained earnings are important to a business as, most businesses are looking to continue their growth, the business owners will use those earnings to maintain operations, increase sales, expand their products/services, or buy back some of the company shares. Retained earnings are reported on the balance sheet or sometimes will be in a separate report; they will also frequently be adjusted and change, as they will react to the various changes and needs of the business.
The last term that business owners may not quite understand is diversification. Diversification is essentially a method used to allocate capital to a variety of investments, so that companies are able to mitigate the risks of having “all of their eggs in one basket”. Primarily, diversification is used to remove or reduce unsystematic risk (a firm-specific risk that affects only one company or a small group of companies). Basically, this means that portfolios that are performing well will balance out the portfolios that are performing poorly, so the company does not lose out if they only invested in one portfolio that is doing poorly.
Even though you are not an accountant, as a business owner you should be aware of accounting terms so that you are better able to understand the finances of your business. Knowing these terms can also help you better understand how each of these terms affect your business and to show the value that your accountant brings to your business.