As a business owner, performing accounting tasks to track your financial activities is crucial to keeping your daily operations going smoothly. Understanding business accounting also helps you plan for the future and so is essential for growing your company.
We’ve listed and defined 12 business accounting terms you need to know to manage your finances effectively, including:
- Self Assessment tax return
- Business expenses
- Assets, liabilities and profits
- Cash flow
- Financial reporting
- Balance sheet, income statement, and cash flow statement
- Making Tax Digital
1) Self Assessment tax return
The Self Assessment system is HMRC’s (HM Revenue & Customs) method for collecting Income Tax that’s not automatically deducted from people’s wages, pensions and savings.
Individuals with income aside from employee income, pensions and savings will need to fill out a Self Assessment tax return. This includes self-employed people, such as sole traders, contractors or directors paid via dividend rather than through their company’s payroll.
Self-employed people who have earned over £1,000 (regardless of any business expenses) should complete a tax return. Most self-employed individuals can take advantage of the tax-free allowance of £12,500 on income, so they may not need to pay tax on anything under this amount. However, you should still report your income to HMRC.
2) Business expenses
Every business has costs they must pay, called business expenses. These expenses can refer to anything from bills to uniform costs. Business expenses typically separate into three main categories:
Fixed expenses are costs that either don’t change at all or only fluctuate slightly over time. Examples of fixed expenses include car payments, WiFi bills, loan repayments and rent.
Variable expenses vary from month to month. Typically, variable expenses refer to supply costs, mileage, utility bills and so on.
Periodic expenses are costs that occur here and there, meaning you only pay them every once in a while, which is why they can be challenging to plan for. For example, if you need money for an unexpected machine replacement or repair.
Assets are anything of value your business owns and come in two categories: current assets and fixed assets.
Current assets are cash or assets that can be converted into cash quickly, including short-term investments, accounts receivable (money that’s owed to you) and inventory. The more current assets you have, the better since you’ll have more funds at hand to pay expenses without borrowing money.
Fixed assets are items that have long-term value to your business, meaning they last longer than one year. These assets can be tangible (physical objects), such as equipment, machinery, or properties, and intangible (non-physical entities), including copyrights or your brand name.
A liability is something your company owes, now and in the future, such as money you owe to suppliers.
Liabilities fall into two categories: current and long-term (or non-current) liabilities. Current liabilities must be paid back within one year, such as credit lines, loans, accounts payable and salaries. Long-term liabilities, like mortgages and bonds, can be paid back after a year.
Current liabilities also include:
- Bank overdrafts
- Sales taxes
- Payroll taxes
- Income taxes
- Outstanding expenses
More examples of long-term liabilities include:
- Capital leases
- Long-term borrowing
- Pension liabilities
- Deferred revenues and taxes
Profit (or net income) is the money you have left from your revenue (money you make from sales) after you’ve paid off your financial obligations like bills, licence fees and loan repayments. Profits come in two types:
- Gross profit – The profit your company made after deducting costs directly linked to selling your goods or services, such as supplies or equipment.
- Net profit – The profit made by your company after deducting all other costs, including taxes and operating expenses like rent and payroll.
While increasing your profits benefits your company’s bottom line (income after all expenses have been deducted from revenues), you also need to know how it affects your cash flow.
6) Cash flow
Cash flow refers to money you bring into your business (your cash inflows) and money you spend on expenses (your outflows). You either generate positive or negative cash flow:
- Positive cash flow is when your business has more money coming in than going out. As a result, you can cover expenses like rent, taxes and other variable costs like new stock. In time, positive cash flow may enable you to expand your business.
- Negative cash flow means that you spend more money than you make. Negative cash flow becomes a problem if it continues for an extended time. You’ll eventually start eating into any reserve funds you have and may even need to close up shop.
If your business is soaring and you make more than you spend, you’re doing something right. On the other hand, if you struggle to balance your cash inflows and outflows, you may need to make some adjustments.
7) Financial reporting
Financial reporting is a crucial part of any business since you need it to understand how and when money leaves and enters your business to determine how successful you are. In addition, you need the correct financial information to make sure you can cover your expenses and manage your business effectively.
Financial reporting is when you record financial information about your business that indicates how your company performs over a specific time period. The documents you use to record this data are called financial statements.
The main financial statements all businesses use are the balance sheet, income statement (or profit and loss statement) and cash flow statement.
8) Balance sheet
The balance sheet is a two-sided chart that lists the value of what you owe (liabilities) on one side and shows what you own (assets) on the other. If the total of each side amounts to the same number, it means your business is financially stable.
The following formula determines the balance sheet:
Assets = liabilities + equity
Your assets are items of value your business owns, ranging from machinery, vehicles, stock, furniture and cash in the bank to smaller items like a fancy coffee machine or office supplies.
Liabilities are what you owe other people or companies. This could be a bank loan, a mortgage on a business property, suppliers fees, taxes you owe HMRC or wages if you have an employee.
Your equity is how much of the assets you own –– if you are the sole owner of the business, this will be an easy calculation.
Once you have totalled up your entire assets and liabilities, subtract the liabilities from the assets, and you have the owner’s equity figure. This calculation essentially shows what would be left over if all assets were sold and debts paid.
9) Income statement
The income statement (or profit and loss statement) shows all your ingoings and outgoings. This statement will show you what your bottom line, or net income, is and if you made or lost money over a period of time.
It’s crucial to get an income statement correct as HMRC taxes you on your net income. Your expenses will also be subtracted from your tax bill, so your income statement is an important document for both yourself and HMRC.
Below we’ve listed some common items you can include in your income statement:
- Revenue or sales: Money you earned through selling your products or services. This will be the first section of the income statement.
- Cost of goods sold: Total direct costs from selling your products and earning revenue, including the cost of work and materials.
- Gross profit: Calculated by subtracting the cost of goods sold from your revenue. You’ll only find this equation on the multi-step income statement.
- Advertising and marketing expenses: Costs connected to marketing your business to attract clients or customers, including paying for digital or print advertising.
- General and administrative expenses: The admin costs linked to running your business, including rent, supplies and travel expenses.
- Earnings before tax: This is your pre-tax income and usually the second-to-last item included on an income statement.
- Net Income: Total revenues minus total expenses. Net income is the last listed item on an income statement. If you subtract your total expenses from your total revenue and get a positive number, your business made a profit. If the number is negative, you made a loss during that period.
10) Cash flow statement
A cash flow statement shows all incoming and outgoing transactions over a period of time, indicating the financial health of your business. It can also highlight issues so that you can create plans for how to solve them.
Cash flow statements provide a detailed view of how you spend your money and in what areas. You use the final number on the income statement (your net income) as part of your cash flow calculations.
If you are looking for funding, a potential investor will be very interested in the cash flow statement to understand where you are spending money and how your business operates.
You’ll need to prepare figures in the following three areas:
- Operations: the payments you need to make to continue trading, including suppliers, stock costs, or potentially shipping charges if you are product-based. If you are a service-based business, this could include wages, equipment or software costs.
- Investing: this covers money invested in items that benefit the value of the business, such as buying more sophisticated equipment or buying and selling assets (physical or intangible).
- Financing: this includes payments made to cover any debts, including repaying loans or invoicing for services.
11) Making Tax Digital (MTD)
Making Tax Digital (or MTD) is a government initiative to reduce the tax gap by ensuring businesses pay the right amount of tax. Small companies frequently submit error-riddled tax returns that account for 43% of the tax gap (roughly £13.4 billion in incorrect tax payments).
MTD seeks to solve this problem by making it easier and more effective for small businesses to file the correct tax returns via digital accounting software. Digital record-keeping through MTD-compliant accounting software helps small businesses better manage their accounts, file taxes on time and avoid under or overpaying HMRC.
Small businesses registered for VAT and above the VAT threshold of £85,000 also need to register for Making Tax Digital for VAT. As such, they’ll need to maintain digital records and submit their VAT returns via digital accounting software.
If you own a VAT-registered business you must register for Making Tax Digital by April 2022 regardless of its turnover but you can register earlier if you want.
If you’re a self-employed worker or landlord that declares an income of over £10,000 via Self Assessment tax returns, then you must register for Making Tax Digital for Income Tax Self Assessment by April 2023.
12) VAT (value-added tax)
VAT applies to purchases of goods, services and other taxable supplies (explained below). It plays a crucial role in business as it can be charged on a range of the products or services you offer.
However, VAT is not a tax on individual businesses –– it’s ultimately your customers that pay the VAT when they buy your product or service. VAT is an indirect business tax since you’re still responsible for reporting it to HMRC (HM Revenue & Customs).
VAT is applied differently depending on your sector and the nature of your business. However, areas that are usually VAT taxable include:
- Sales of your goods or services
- The hire or loan of your goods
- Exchanges like swapping a new product for a customer’s old one
- Staff sales like meals or business trips
- Business goods you use personally
- The sale of business assets
Now that you’re up to speed on these must-know business accounting terms, we hope you’ll find your financial management much easier!
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