20 Accounting Terms Every Business Owner Should Know
Running a business means making financial decisions every day. Is it time to hire? Are prices keeping pace with costs? Can the business afford a major purchase? Why are sales increasing, but cash still seems tight?
Your financial statements contain information that can help answer those questions. Being familiar with the accounting concepts behind the numbers can make those reports easier to understand and provide useful context when discussing your business with your accounting team.
Some of these terms may already be familiar. Others may appear regularly on financial reports without getting much attention. Understanding what they mean and how they relate to one another can give you a better foundation for conversations about your company’s profitability, cash flow and overall financial position.
Here are 20 basic accounting terms and concepts that can help you better understand the financial information you see and the discussions you have about your business.
The Building Blocks
1. Assets
Assets are resources your business owns or controls that have economic value. Cash is an asset, but so are accounts receivable, inventory, equipment, vehicles and real estate.
Assets are separated into current and long-term categories. Current assets include cash and other assets expected to be converted to cash, sold or used within one year or the business’s normal operating cycle. Long-term assets include property, equipment and other resources the business expects to use over a longer period.
That distinction can be important when evaluating the company’s financial position. A business may have substantial assets, for example, but much of that value could be tied up in equipment, inventory or customer receivables rather than readily available cash.
2. Liabilities
Liabilities are amounts the business owes to others. Accounts payable, credit card balances, accrued expenses, taxes payable and business loans are common examples.
As with assets, timing matters. Current liabilities are obligations expected to be paid within one year, while long-term liabilities extend beyond one year.
Simply knowing that a business has $500,000 in assets does not tell you very much without knowing what it owes. A company with $500,000 in assets and $100,000 in liabilities is in a very different financial position from one with the same assets and $450,000 in liabilities.
3. Equity
Equity represents the owners’ financial interest in the business. At its most basic, it is what remains after liabilities are subtracted from assets.
These three concepts are connected by the fundamental accounting equation:
Assets = Liabilities + Equity
If a business has $500,000 in assets and $300,000 in liabilities, for example, the remaining $200,000 represents equity.
Equity does not remain static. It changes as the company earns profits or incurs losses, and as owners make contributions, take distributions, or complete other transactions that affect the business. Reviewing changes in equity over time can provide another perspective on how the company’s financial position is evolving.
Tracking Revenue, Expenses and Profit
4. Revenue
Revenue is what a business earns from its primary activities before related expenses are deducted. It is often called the “top line” because of where it appears on the income statement.
Business owners naturally pay close attention to revenue, particularly when the company is growing. But sales growth by itself does not necessarily mean the business is becoming more profitable.
A company could increase revenue by 20% while its costs increase by 30%. Sales are higher, but the business may not be financially stronger. That is why revenue is best considered alongside costs, margins and profitability.
Looking at revenue trends over time can also help identify important questions: Are sales growth and profitability moving together? Are pricing changes keeping pace with rising costs? Is the business generating enough return from the resources being invested to support continued growth?
5. Expenses
Expenses are the costs incurred in operating the business and generating revenue. Payroll, rent, insurance, advertising, professional fees, utilities and software are just a few examples.
Some expenses are fixed expenses, meaning they remain relatively stable regardless of sales volume. Others are variable expenses, meaning they rise and fall with business activity. Understanding these differences can be helpful when budgeting, setting prices, evaluating profitability, and planning for growth.
If sales increase substantially, certain costs may be expected to rise along with them. For example, a growing business may need additional employees, inventory, or technology to support higher demand. However, an increase in expenses that does not contribute to additional revenue, improved efficiency, or long-term business goals may deserve a closer look.
6. Cost of Goods Sold (COGS)
Cost of goods sold, or COGS, represents the direct costs associated with the goods a company sells. Depending on the business, that may include inventory, materials, direct labor and certain production costs.
These costs are separated from broader operating expenses such as administrative salaries, office rent or advertising.
For businesses that provide services rather than products, the terminology and accounting treatment may differ. The underlying question, however, is still useful: What does it cost the business directly to deliver what it sells?
Understanding those costs leads to another important number, gross profit.
7. Gross Profit
Gross profit is calculated by subtracting cost of goods sold from revenue.
Suppose a company generates $1 million in revenue and incurs $600,000 in COGS. Its gross profit is $400,000.
That does not mean the company earned $400,000 in net income. The business still has operating expenses and potentially interest, taxes and other costs. But gross profit provides a useful look at how much remains from sales before those additional expenses are considered.
Comparing gross profit from one period to another can also help show whether growth in sales is translating into growth in the dollars available to cover the rest of the company’s expenses.
8. Gross Margin
Gross margin takes gross profit a step further by expressing it as a percentage of revenue.
Using the example above: ($1,000,000 minus $600,000) divided by $1,000,000 = 40%
In other words, 40 cents of each revenue dollar remains after the costs included in COGS.
The trend is often more informative than the percentage by itself. Suppose revenue is increasing, but gross margin falls from 40% to 34%. Higher sales may be masking another change in the business. Material or labor costs may have increased, pricing may not have kept pace, discounts may be more aggressive, or customers may be buying a different mix of products or services.
A change in gross margin does not necessarily indicate a problem, but it can tell you where to start asking questions.
9. Net Income
After the other expenses reflected on the income statement are taken into account, the business arrives at net income, often referred to as the “bottom line.”
Net income tells you whether the company generated a profit or loss for the period under the accounting method being used.
It is an important number, but it should not be viewed in isolation. If net income increased, was it because sales improved, margins improved or expenses declined? If it decreased, what changed?
There is also another important distinction. Net income does not tell you how much cash the company has available.
Cash Flow and Liquidity
10. Cash Flow
Cash flow refers to the movement of money into and out of a business. It focuses on the actual cash available, which can be different from profit reported on the income statement.
A company can report a profit and still experience cash pressure if money is tied up in receivables, used for inventory, invested in equipment, or applied toward debt.
Cash flow is important because it helps explain whether a business has enough available cash to meet its obligations, fund operations, and support growth.
11. Accounts Receivable
Accounts receivable (A/R) represents amounts customers owe your business for products or services already provided on credit.
Receivables are assets because the business expects to collect the money. But until the customer pays, that receivable is not cash available to cover payroll, make a loan payment or pay a supplier.
An increasing A/R balance is not automatically a concern. If sales are growing, receivables may naturally grow with them. What may deserve attention is whether receivables are increasing faster than sales or whether customers are taking longer to pay.
A business can report strong sales while still experiencing cash flow pressure if customers have not yet paid for a significant portion of those sales.
12. Accounts Payable
Accounts payable (A/P) represents amounts the company owes vendors and suppliers for goods or services it has received but has not yet paid for.
Payables allow a business to purchase on credit rather than paying immediately, which can help with cash management. At the same time, they represent upcoming demands on cash.
Reviewing receivables and payables together can be particularly useful. A company may expect significant customer payments next month, but if large vendor obligations come due first, it could still face a short term cash need.
13. Working Capital
Working capital provides another way to look at the company’s short term financial position. It is calculated as:
Current Assets minus Current Liabilities
If a company has $300,000 of current assets and $225,000 of current liabilities, it has $75,000 in working capital.
Positive working capital means current assets exceed current liabilities. But the composition of those current assets also matters. $100,000 sitting in cash is different from $100,000 tied up in slow moving inventory or overdue receivables.
Working capital is therefore more useful as part of a broader financial analysis than as a simple pass or fail measure. Appropriate levels can vary considerably depending on the company’s industry, operating cycle and business model.
Accounting Methods and Concepts
14. Cash Basis Accounting
Cash basis accounting records income when payment is received and expenses when they are paid.
The concept is relatively intuitive because the accounting follows the movement of cash. If a customer pays the business in August, the receipt appears in August under the cash method, even if the related work was completed earlier.
However, timing can sometimes make operating results harder to compare. A large customer payment received this month may relate to work performed previously, while an expense paid today may relate to a different period.
Cash basis accounting can provide a useful view of actual cash movement, but it may not always show when revenue was earned or when expenses were actually associated with generating that revenue.
Understanding the basis used to prepare financial statements is important when interpreting the results.
15. Accrual Basis Accounting
Accrual accounting records revenue when it is earned and expenses when they are incurred, rather than simply following when cash changes hands.
Suppose a company completes a $20,000 project in August and invoices the customer, who pays in September. Under accrual accounting, the revenue may be reflected in August because that is when the company earned it, even though the cash does not arrive until September.
This approach helps financial statements better reflect the activity of the period being reported. However, it also means an income statement and the company’s bank balance can appear to tell different stories because they are measuring different things.
The appropriate accounting method depends on the nature of the business, applicable accounting and tax requirements, and the type of financial information the company needs. When reviewing financial reports, it is important to know which basis is being used so the numbers can be interpreted in the proper context.
16. Depreciation
Depreciation is the accounting method used to allocate the cost of a long-term asset over the period the business expects to use it.
Suppose a company purchases a piece of equipment that it expects to use for several years. The cash to purchase the equipment may leave the bank account immediately, but for financial accounting purposes, the cost of that asset is recognized as depreciation over its useful life rather than entirely in the year of purchase.
Because depreciation is a non-cash expense, it reduces reported income but does not represent a current cash payment. As a result, the timing of the cash outlay and the accounting expense can be very different.
Tax rules add another layer. The timing and amount of tax depreciation can differ from the depreciation shown in financial statements, and various tax provisions may affect the treatment of qualifying purchases.
The important distinction is that cash spent, book expense, and tax deduction are not necessarily the same amount or recognized at the same time.
Reading Your Financial Statements
The concepts above become particularly useful when reviewing the company’s financial statements. Each of the three primary statements looks at the business from a different perspective.
17. Income Statement (P&L)
The income statement, commonly called the profit and loss statement or P&L, shows revenue, expenses and profit or loss over a particular period.
In simple terms, it helps answer:
How did the business perform during this period?
But the bottom line is only one part of the story. Compare revenue with prior periods. Look at gross profit and gross margin. Identify expenses that changed significantly. Consider whether profit is growing at the same rate as sales.
A P&L becomes much more useful when the focus goes beyond what happened to include what changed and why.
18. Balance Sheet
The balance sheet provides a snapshot of the company’s financial position at a particular point in time.
It brings us back to the basic accounting equation:
Assets = Liabilities + Equity
The balance sheet shows what the business owns or controls, what it owes and the owners’ financial interest in the company.
It can also reveal things the P&L does not. Receivables may be climbing. Debt may be declining. Inventory may be building. Cash may be shrinking even during a profitable period.
Looking at balance sheets from several periods side by side can be particularly useful because changes in those accounts often tell a story that is not apparent from a single month’s results.
19. Statement of Cash Flows
The statement of cash flows helps explain how cash moved into and out of the company during a particular period.
Cash flows are grouped into three categories:
- Operating activities, which relate to the company’s primary business operations.
- Investing activities, which can include purchases and sales of long term assets.
- Financing activities, which can include borrowing, repaying debt and certain transactions involving owners.
This statement can help answer a question that frequently comes up when reviewing financial results:
If the business made a profit, where did the cash go?
Cash may be tied up in receivables, used to purchase equipment, or applied toward paying down debt. The statement of cash flows helps explain why the company’s cash balance changed during the period and where that cash came from or went.
20. Financial Ratios and Trends
The final concept is not a single account. It is the practice of putting financial numbers into context.
A number by itself often does not tell the full story. A 38% gross margin might be strong for one company and concerning for another. What may be more informative is how that margin compares with prior periods, the company’s expectations and relevant industry benchmarks.
The same principle applies to revenue growth, receivables, working capital, debt and other financial measures.
Rather than trying to monitor every possible ratio, businesses can identify the measures that are most meaningful to their operations and track them consistently.
The direction of those numbers can be especially important. A gradual decline in gross margin, a steady increase in the time customers take to pay or expenses that consistently grow faster than revenue may be worth examining even when the company’s overall results remain positive.
How the Numbers Fit Together
The real value of accounting information comes from seeing how these concepts connect.
Suppose your company’s revenue increased 15% this year and net income also improved. On the surface, that is good news.
But suppose gross margin declined at the same time. Accounts receivable increased 30%, and customers are taking longer to pay. The company also purchased new equipment and made substantial payments on outstanding debt.
The financial picture is now more nuanced.
The company is growing and profitable, but the decline in gross margin may deserve attention. Cash may also be under pressure because more money is tied up in receivables while cash is being used for equipment and debt payments.
Not every unfavorable change in the numbers signals a problem. A temporary decline in net income may reflect investments the company made to support future growth. An increase in debt may also have different implications depending on why the business borrowed and how the funds are being used.
This is why financial statements are most valuable when they are reviewed together, compared over time and considered in the context of what is actually happening in the business.
Putting the Numbers to Work
Understanding these accounting terms is a good starting point. The greater value comes from understanding what the numbers mean for your business.
Financial statements can show you what happened, but they can also help you understand why it happened and what may deserve attention next. A change in gross margin, an increase in receivables or a tightening cash position may mean something very different from one business to another.
Whether you are considering a new hire, evaluating pricing, planning an equipment purchase, managing cash flow or thinking about your next stage of growth, good financial information can provide a stronger foundation for those decisions.
That is where regular conversations with your accounting team can be valuable. We can help you look beyond the individual numbers, identify trends and put the results in the context of your operations, goals and plans.
If you would like a clearer understanding of what your financial statements are saying about your business, talk with us. The value is not just knowing the numbers, but knowing what they mean and how they can support better decisions.
