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Basics of Accounting for entrepreneurs

Author: Miguel Teixeira
Updated at:2017-12-11
Tags: Finance, accounting, entrepreneurship

An entrepreneur doesn't need to be an accountant, but understanding a balancesheet, a income statement and cashflow is paramount.

The business and the entrepreneur

The first basic concept you need to grasp is that you and your company are two different entities. Think of your business as another person. It has its own resources, debts, income and costs, its own needs. Very often owners think of the business numbers as their own, and they are clearly not the same.

Cost based accounting

The second basic concept you need to understand is that your assets will be valued based on their costs. Not on their commercial value. For instance, if you have a grocery shop and you order cookies at 50 cents a package and retail it for 1$, the value registered in your account will be the 50 cents. Not the 1$. There are other issues that influence its value, like amortization and depreciation, but we will talk about those later on.

Transaction based accounting

Third basic concept is that in the income statement and the balance sheet, changes happen when the transaction take place and not when the good and money are exchanged, more precisely, when you receive or send a receipt. That constitutes a transaction. Later on, when the payment is made, the cashflow will be affected, because the cashflow statement follows cash events and not transaction based events.

Documents produced from accounting

There are three main documents that are produced from accounting:

  • Balance Sheet - a photography of your business financials in a given moment, where you can see what your company owns and owes,
  • Income statement - the income statement which describes how well did you do in a period of time, usually a year, and it relates to revenues and costs,
  • Cashflow Statement - the cashflow statement describes the flow of cash during a period of time. It allows you to understand:
    1. Where your cash came from
    2. How your cash was spent
    3. If your cash status has improved

We will be showing you examples of these documents so that you can go along as we explain them.

Balance sheet

A balance sheet has two major groups divided into columns:

  • Assets (on the left side) - it states all that your company owns,
  • Equity and Liabilities (on the right side) - in plain terms, it states where the money, to acquire what the company owns, came from.
balance sheet example

The total amount in the left side, Assets, should always be equal to the total amount on the right side, Equity and Liabilities.

The right side itself is divided in two major groups:

  • Liabilities - is what your company owes (to yourself included),
  • Equity - is basically the remainder between what the companies owns and what it owes. Equity should not be confused with the value of the company, because of the very nature of accounting being a cost based system and not a value based system. But let's say you do not want to be negative on equity.

Cost vs Investment vs Paying debt vs Revenue

Sometimes it's hard to understand the difference between Cost, Investment, Paying debt and revenue. Basically putted:

  • Cost is when some asset is consumed, you lose its value and you are not paying debt. For instance, when you pay salaries, or electricity bills, you spend an asset: cash.
  • When you are paying debt, you are also removing an asset (cash) from your balance sheet, but at the same time and for the same amount you are reducing your liabilities.
  • In an investment you are exchanging an asset for another asset of the same value. For instance when you buy a 700$ computer, you subtract 700$ from cash, but at the same time you now own a 700$ computer that will be registered in your asset side of the balance sheet (tangible assets).
  • Revenue is when you sell something and here there are two scenarios:
    1. Products - Selling a product you will sell something that is registered in your balance sheet and that is a cost, but at the same time you will be adding cash to your asset side (note that if you are doing things right and selling at a profit, you should be adding more than removing).
    2. Services - When selling a service you aren't removing any asset, only adding cash.

Now, if you remember, in the top of paragraph we stated that the two sides of the balance sheet should always have the same amount. However now we have increased on the left side. So what happens on the right side to compensate it?

Income statement and Equity

The income statement reflects if you are profitable or not. If you are profitable, it basically means that in your balance sheet assets minus liabilities has become more positive. So there is direct connection between income statement that the balance sheet and it is place inside the equity. It is called retained earnings.

income statement example

In the income statement itself you register Revenues, and the costs of goods sold. Costs of goods sold might be a product or service you have acquired in order to resell it.

So now if you subtract costs of good sold to the revenue you will reach gross profit.

After gross profits, you register all other operational expenses, like salaries, electricity bills, etc. Within operational expenses, you should include depreciation and amortization. Then you calculate your operational income by applying the following formula:

Operational income = Gross profit - Operational expenses.

To calculate your income from financing, add financial revenue (example: interests you earn on deposits) and subtract all your financial costs (example: interests you have to pay on your loans).

After that, you calculate your Net Earnings before taxes applying the following formula:

Net Earnings before taxes = Operating income + Income from financing

Now you deduct your taxes and finally you reach the end result: Net Income.

Depreciation, Amortization and interests

When you ask a loan for 100k, you register on your balance sheet that value into your liabilities, but not the interests. Interest are a cost that is related to your yearly expenses and they affect your income statement directly.

Depreciation and amortization are probably the hardest concept to grasp in accounting so, let's try to demystify them. Let's say your business buys a car for 15K, so you get an asset named car that is valued in 15K. However, next year the car isn't valued at 15K anymore and the way that is translated into accounting is through depreciation. Basically, your car value will be depreciated at a rate defined by the government and that depreciation is accounted as a cost and subtracts on the balance sheet. Amortization is similar, but while depreciation applies itself to tangible assets (like cars, flats, machines), amortization applies to intangible assets (like domains, franchising agreements, pictures, films, etc).

Cashflow statement

This statement in some countries is not mandatory. But because the main goal of a company should be to create free cashflow (dividend + investment), and many companies fail to manage their cash effectively, we will talk briefly about it. As the name indicates, it refers to the flow of cash inside a company. There are two methods to calculate cashflow: the direct and the indirect method. We will focus in the indirect method, that is in our opinion easier to understand. The rationale behind it, is to start with your income statement and then work from there to create a cash based system.

cashflow statement example

Here is the process:

Basically, the process is that, when you calculate your net income you include costs that are not cash based, like amortization and depreciation. So the first thing you do is removing that effect by adding them to your income statement.

Another difference is that cashflow is a cashed based system, in opposition to the income statement which is a transaction based system. So, there is a difference between issuing a receipt for your services and getting payed. As well as purchasing a product or service and paying for it. When you issue a receipt you are making the sale and, as such, it appears in your income statement. During the period that goes between the transaction and the payment the value either goes, in your balance sheet, to account receivables (liability) or account payable (assets) depending if you owe or if your clients owe you.

To reach your net cashflow from operating activities you need to use the following formula:

Net income + Amortization + Depreciation + Difference in accounts payable - Difference in accounts receivable - Difference in inventory

Then you calculate your company's Net Cash flow from investing activities. So you add up all your investments and capital expenditures. Each investment is money leaving the company and, as such, it should have a negative value. On the other hand, any time you sell an asset that was an investment you register that inflow of cash as positive.

Finally, you get to financing activities and here you subtract any outgoing flow of cash like dividends, or paid loans, and add any new loans and capital increases since it represents an inflow of cash. Now to finish, and to calculate if you business has now more cash or less cash than it did in the previous period, you apply the following formula:

Net Increase (decrease) in cash and cash equivalents = Net cash from operating activities + Net Cash from investing activities + Net cash flow from financing activities.

Final Remarks

We recommend you to get a good accountant and try to understand thoroughly your accounting documents. They will give you some valuable information of how your company is doing. Although it is not what we would recommended as a dashboard for your company, it offers valuable insights and it will help you make decisions.