Basics of Small Business Accounting For Beginners - What You Need To Know
Updated on August 19, 2023 by Tim Donahue
Learn the basics of small business accounting quickly with this guide for beginners
This guide will walk you through the basics of small business accounting and set you on the right path. We’ll explain each component in detail, ensuring you have a firm grasp on what you need to do and why it’s important.
Table of Contents
- Open a Small Business Bank Account
- Track Your Small Business Expenses
- Develop a Bookkeeping System
- Understanding Balance Sheets
- Understanding Profit & Loss Statements
- The Importance of Properly Categorizing Every Entry
- How to Pay Yourself: Payroll or Draw?
- Paying Employees: Small Business Payroll System
- Establish Sales Tax Procedures
- Determine Your Tax Obligations
- Calculate Profits, EBIT, and Gross Margin
- Find High-Quality Accounting Partners
- Periodically Re-evaluate Your Methods
- Next Steps You Can Take To Get Started
Open a Small Business Bank Account
Once your business is legally set up (more on how to Choose a Business Structure here), it’s crucial to open a separate bank account exclusively for your business transactions. This helps to separate personal finances from business ones, simplifying bookkeeping and making tax time much easier.
Most importantly, it helps provide a clear financial picture of your business at all times. Check out our guide on what a small business needs to start for more detailed information.
The most important thing about managing a small business checking account and your business finances is to remember to keep your personal finances SEPARATE from your business finances.
There should be no co-mingling of money between your business checking account and your personal finances, unless you enter a proper line item explaining why money was passing between the two accounts.
Things not to do: Don’t pay for a business lunch with your personal credit card. Don’t buy business equipment with your personal cash. Don’t use business credit card to pay for your personal expenses.
Examples of how you might co-mingle your personal and business accounts correctly: You will probably make a loan to your business from your personal account to get your business started. That’s fine.
Make sure to categorize the loan amount as a CREDIT and as a LOAN, with a note such as “Loan from personal checking account”. Then later, you might pay back that loan from your business acct to yourself and you would categorize that payback amount as a DEBIT and a LOAN REPAYMENT (even if it’s a portion of the original loan) with a note like “Payback loan from personal acct”.
The critical point here is that you have made clear entries so your bookkeeping reflects where every dollar come from or went. By doing this properly, you can do your taxes and any accounting, with confidence and certainty.
Track Your Small Business Expenses
Keeping a close eye on your business expenses is a key part of the basics of small business accounting. This involves tracking all outflows of money from your business, such as rent, supplies, and payroll. It’s wise to use software like QuickBooks or Wave to simplify and automate this process. They will help you categorize your expenses correctly and prepare financial reports effortlessly.
Develop a Bookkeeping System
Bookkeeping is the process of recording all financial transactions in your business. This includes sales, expenses, and payments received. Effective bookkeeping is essential as it ensures all financial transactions are accurate, up-to-date, and comprehensive. This data then feeds into your financial reports, like your Balance Sheet and Profit and Loss Statement.
Understanding Balance Sheets
A balance sheet is a snapshot of your business’s financial position at a specific point in time. It outlines your assets (what your business owns), liabilities (what your business owes), and equity (the owner’s investment in the business).
It’s crucial for understanding the financial health of your business and for making informed business decisions. Here, you’ll see items such as cash, equipment (assets) along with outstanding debts like fees owed to suppliers or payroll (liabilities).
Example of a Balance Sheet
| Amount ($) | |
|---|---|
| ASSETS | |
| Cash | 10,000 |
| Office Equipment | 5,000 |
| Total Assets | 15,000 |
| LIABILITIES | |
| Outstanding Supplier Payments | 3,000 |
| Outstanding Payroll | 2,000 |
| Total Liabilities | 5,000 |
| EQUITY | |
| Owner’s Capital | 10,000 |
| Total Equity | 10,000 |
In this simplified example, total assets of $15,000 equals the total of liabilities ($5,000) and equity ($10,000), thereby maintaining the balance in the balance sheet.
Understanding Profit & Loss Statements
Also known as an income statement, a Profit and Loss Statement shows your revenues, costs, and expenses over a period of time. This statement provides an overview of your business’s profitability. You can observe how your revenue is covering your expenses and whether your operations are profitable. This statement is a key tool for decision-making and is often required by lenders and investors.
Example of a Profit and Loss Statement
| Amount ($) | |
|---|---|
| REVENUE | |
| Sales | 30,000 |
| Total Revenue | 30,000 |
| EXPENSES | |
| Cost of Goods Sold | 10,000 |
| Payroll | 8,000 |
| Office Rent | 2,000 |
| Total Expenses | 20,000 |
| Net Profit or EBIT (Revenue – Expenses) | 10,000 |
In this simplified example, the total revenue is $30,000. After subtracting the total expenses of $20,000, we are left with a net profit of $10,000.
The Importance of Properly Categorizing Every Entry
Proper categorization of each transaction entry ensures accuracy in your financial reports. Whether it’s income, expenses, assets, or liabilities, each entry should be classified correctly. This is how you will ensure that you know where your money is coming from and going, enabling better business decisions. It also keeps your tax reporting accurate and compliant.
Proper categorization of each transaction entry ensures that your bookkeeping is accurate at all times. It’s a must!!
How to Pay Yourself: Payroll or Draw?
As a small business owner, you have a choice in how you receive income from your business – via owner’s draw or payroll. An owner’s draw is a portion of the business profits that you withdraw for personal use.
On the other hand, payroll refers to a fixed salary that you pay yourself, similar to how an employee gets paid. Deciding between the two often depends on your business structure and tax considerations. You may want to consult with an accounting partner for advice tailored to your situation.
Paying Employees: Small Business Payroll System
When you hire employees, it’s essential to set up a payroll system to manage their payments and deductions. This involves not just their wages, but also withholdings for taxes and benefits. Implementing a reliable payroll system ensures you comply with legal obligations and helps retain happy, productive employees. Our article on the three main parts of a successful small business dives deeper into this.
Establish Sales Tax Procedures
If your business sells goods or services, you likely need to collect sales tax. Sales tax procedures involve determining when sales tax applies, calculating the correct amount, collecting it from customers, and paying it to the correct tax authorities. This can be complex as tax laws vary by location and product type, but online accounting software can often automate this process.
Determine Your Tax Obligations
Taxes are a fact of life for every business. Your tax obligations will depend on your business structure, types of products or services you offer, and where you operate. Typical taxes include income tax, payroll tax, and sales tax. Understanding these obligations, planning for them, and paying them on time is crucial for avoiding penalties and keeping your business in good standing.
Calculate Profits, EBIT, and Gross Margin
Understanding your profits, Earnings Before Interest and Tax (EBIT), and gross margin is a key part of small business accounting.
Your profit is the amount left over after all costs and expenses are subtracted from your revenue.
EBIT (Earnings Before Interest and Taxes) is a measure of your company’s profitability that excludes interest and income tax expenses.
Gross margin is the difference between sales revenue and cost of goods sold, divided by sales revenue, expressed as a percentage.
Understanding these metrics can help you track your business’s performance and identify areas for improvement.
Find High-Quality Accounting Partners
Eventually, you should allow the experts to help with your accounting. As your business grows, you may want to consider working with accounting partners like bookkeepers or accountants. They can provide expert guidance, help you manage complex accounting tasks, and give advice on financial decisions. Be sure to choose someone experienced in small business accounting who understands your industry.
Periodically Re-evaluate Your Methods
Your accounting needs will evolve as your business grows and changes. Regularly re-evaluating your accounting methods helps ensure they still suit your business and comply with any changes in tax laws or accounting standards. For instance, you might switch to a different accounting software as your transactions increase, or you might start working with an accountant once your financials become more complex.
Next Steps You Can Take To Get Started
- Open a separate bank account for your business. (Your bank will require some paperwork showing that you have set up a Sole Proprietorship, an LLC, S-Corp or some kind of business entity.)
- Start tracking your business expenses diligently.
- Set up a bookkeeping system.
- Understand how to read and use a Balance Sheet and Profit & Loss Statement.
- Ensure each financial entry is correctly categorized.
- Decide how to pay yourself – through an owner’s draw or payroll.
- If you have employees, establish a reliable payroll system.
- Set up procedures for dealing with sales tax.
- Determine and plan for your tax obligations.
- Learn how to calculate and interpret key financial metrics such as profits, EBIT, and gross margin.
- Consider working with an accounting partner as your business grows.
- Regularly re-evaluate your accounting methods and make changes as needed.
Glossary of Common Accounting Terms
| Term | Description |
|---|---|
| Accounts Payable | Amounts owed by a business to suppliers or vendors for goods or services purchased on credit. |
| Accounts Receivable | Amounts owed to a business by customers who have purchased goods or services on credit. |
| Assets | Anything of value that a business owns or controls, including cash, inventory, equipment, and real estate. |
| Balance Sheet | A financial statement that provides a snapshot of a business’s assets, liabilities, and equity at a specific point in time. |
| COGS (Cost of Goods Sold) | The direct costs associated with the production of the goods sold by a company. This includes the cost of the materials used in creating the good along with the direct labor costs involved in the production. |
| Credit | In double-entry bookkeeping, a credit is an entry recording a decrease in assets or an increase in liabilities and equity on a company’s balance sheet. |
| Debit | In double-entry bookkeeping, a debit is an entry recording an increase in assets or a decrease in liabilities and equity on a company’s balance sheet. |
| Depreciation | The decrease in value of a long-term asset (like equipment or real estate) over time, due to wear and tear or obsolescence. |
| EBIT (Earnings Before Interest and Taxes) | A measure of a firm’s profit that includes all incomes and expenses (operating and non-operating) except interest expenses and income tax expenses. |
| Equity | The residual interest in the assets of a business after deducting liabilities. In other words, what the business owners would receive if all assets were sold and all debts paid. |
| Expenses | Costs incurred by a business in the process of earning revenue, such as wages, rent, and utilities. |
| Gross | The total revenue generated by a business, before subtracting any costs or expenses. |
| Gross Margin | Total sales revenue minus the cost of goods sold, divided by total sales revenue, expressed as a percentage. It shows the profitability of each sales dollar before deducting overhead costs and interest expenses. |
| Liabilities | Debts or obligations owed by a business, including loans, accounts payable, and salaries payable. |
| Net | The amount remaining after all deductions have been made. For example, net income is the profit after deducting all business expenses from gross revenue. |
| Net Income | Total revenue minus total expenses. Also known as net profit or net earnings. |
| Profit & Loss Statement | A financial statement that summarizes the revenues, costs, and expenses incurred during a specific period of time, typically a fiscal quarter or year. |
| Revenue | The total amount of money generated by the sale of goods or services. Also known as sales or turnover. |
| Tax Obligations | The requirement to pay taxes to government entities, based on the type of business, the location, and the net income. |
| Working Capital | A measure of a company’s operational liquidity. It is calculated as current assets minus current liabilities. |
Conclusion
Accounting is a critical aspect of running a small business. While it might seem intimidating at first, understanding the basics can greatly simplify the process.
Remember, your accounting practices should evolve as your business grows, and it’s important to continually learn and adjust your methods as necessary. With these small business accounting basics under your belt, you’ll be well on your way to keeping your finances in check and your business thriving.
