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Finance and accounting impact every aspect of your business to varying degrees, so it makes sense to have an understanding of some of the key financial terms you’re likely to encounter.
Even if you use an accountant or have an in-house finance team, furthering your knowledge in these areas will enable you to make more informed business decisions, understand their implications, and maintain an effective accounting system.
Here are 25 financial terms to get started with:
1. Accounts payable
Accounts payable refers to money that a business owes to suppliers and creditors for the goods or services it has received but not yet paid for. Examples include utility bills, transportation and logistics, and equipment or raw materials purchased on credit.
Recorded as a current liability on the balance sheet, accounts payable is short-term debt that needs to be settled within the upcoming year, by the payment terms stated on the bills or invoices (e.g. within 30 days of the date of issue, or by a specified date).
2. Accounts receivable
Accounts receivable is the opposite of accounts payable. It refers to all of the money that customers owe to a business for goods or services they have received on credit.
It is recorded as a current asset on the balance sheet, with payments expected from customers (‘debtors’) within the upcoming year.
3. Accounting period
An accounting period is any set period used for financial reporting, including the preparation of accounts and tax returns. Most accounting periods span 12 months, six months, a quarter (three months), or one month.
Business transactions that occur within any set timeframe are included in the financial statements and reports for that accounting period, providing an overview of the activity and performance of the business during that time.
If you operate your business as a limited company, you will have a Corporation Tax accounting period. You will report all transactions that fall within that timeframe (usually 12 months) in your annual Company Tax Return. It will normally correspond with the financial year covered in your annual accounts.
The accounting period for VAT is different – it normally spans only three months. If you register your business for VAT, you will need to prepare a VAT Return at the end of each VAT accounting period.
If you are registered for Self Assessment, your accounting period will usually cover 12 months and corresponds with the tax year (e.g. 6 April 2023 to 5 April 2024).
4. Accrual accounting
Accrual accounting is one of two principal accounting methods (the other being cash basis accounting). With this method, income and expenses are recognised as soon as the transactions occur (i.e. when invoices are sent or received), rather than when the related money is actually received or paid by the business.
Also known as traditional accounting, accrual basis accounting is more complex and time-consuming than the cash basis method. Nevertheless, it is the standard accounting practice used by most businesses, because it provides a more accurate snapshot of financial health.
Amortisation is an accounting method used to incrementally write down (reduce) the value of an intangible asset (e.g. a licence, lease agreement, web domain, goodwill, or intellectual property) over its expected useful life.
For example, if you purchase a software licence for £5,000 and it expires after five years, the asset has a useful life of five years, so you would record an amortisation expense of £1,000 per year for five years.
Amortisation can also refer to the gradual reduction of a fixed-rate loan through equal repayments to the lender over a set period. With an amortised loan, the repayments cover both the loan principal and the interest.
This financial term refers to tangible and intangible resources that your business owns and uses for business-related purposes. Examples include:
- Current assets – cash, accounts receivable, inventory, and marketable securities (e.g. company shares)
- Fixed assets – commercial property, plant and machinery, equipment, and business vehicles
- Intangible assets – trade marks, copyrights, patents, designs, business licences, franchises, goodwill, brand reputation, and customer lists
All of these assets contribute to the present and/or future monetary value of your business. They are a key feature of your balance sheet.
7. Balance sheet
A balance sheet is a key financial statement that shows exactly how much a business is worth at a given point in time. It provides a ‘snapshot’ of its current financial position.
Specifically, the balance sheet communicates what the business owns (its assets), what it owes (its liabilities), and the value of the owners’ investments (their equity) at a particular date.
If you run your business as a limited company, you must include a balance sheet in your annual accounts for Companies House and HMRC.
8. Cash basis accounting
Cash basis accounting is the simpler of the two main accounting methods (the other being the traditional accrual basis). With this method, income is only recorded when it is received, and expenses are only recorded after they have been paid.
Whilst not as comprehensive as accrual accounting, cash basis is often ideally suited to smaller businesses with straightforward income and expenses. However, for most companies, it does not provide an accurate view of financial health.
9. Cash flow
Cash flow is a financial term that causes a great deal of confusion to many people. It refers to the net amount of money flowing into and out of your business at a particular point in time – the cash that your business receives (income) and spends (expenditure).
For example, when you purchase inventory and pay staff wages, money flows out of your business to your suppliers and employees. Whereas, when you sell goods or services, or receive payment for an outstanding invoice, money flows into your business from your customers.
Cash flow can either be positive or negative. Positive cash flow occurs when your business has more money coming in than it has going out. This is what you want to see in the long term. Negative cash flow, on the other hand, indicates that your business is spending more money than it is bringing in.
10. Capital gain
Capital gain is the profit you make when you sell or trade a capital asset that has increased in value since the time you acquired it.
Capital assets are tangible items or intangible property that will be useful to your business over a long period. Examples include land and buildings, vehicles, machinery, computer equipment, tools, furniture, and intellectual property.
If you dispose of any such assets and make a gain, you may have to pay Capital Gains Tax if you are a sole trader or in a business partnership. Limited companies pay Corporation Tax on any gains they make from selling their assets.
If you sell a capital asset for less than you originally paid for it, that would be classed as a capital loss.
11. Cost of goods sold (COGS)
Cost of goods sold (COGS) is a key financial term related to production. It refers to all of the direct, variable costs and expenses incurred in the purchase, production, or delivery of goods or services that a business sells to its customers.
Examples include the cost of products intended for resale, raw materials, parts used to make a product, direct labour, and utilities.
COGS does not include indirect or fixed business costs, such as rent, leases, marketing, insurance, distribution costs, utilities, and salaries not directly related to the production or delivery of the products.
This financial term refers to the process of incrementally deducting the total cost of a fixed (tangible) business asset over time, as it gradually reduces (depreciates) in value due to wear and tear. Doing so gives you greater control over your finances.
The useful life of the asset determines the number of years over which you can spread the cost and record depreciation. For example, if you purchase a laptop for £1,500 and it has an expected useful life of around four years, depreciation will be £375 per year for four years.
13. Double-entry bookkeeping
Double-entry bookkeeping is one of the two main types of bookkeeping systems. The other is known as single-entry. Most firms, including many small businesses, use the double-entry system.
With double-entry bookkeeping, every transaction has two sides and is recorded twice – as a debit entry in one account and as a credit entry in another account.
Essentially, this system requires that for every debit or credit in one account, an equal and opposite entry must occur in another account. The total debits and total credits must balance at all times. If they do not, you know there’s an error somewhere.
For example, let’s say your company obtains a business loan of £10,000. The company’s assets increase by £10,000, so you will record the transaction as a debit in the asset account. At the same time, the company’s liabilities also increase by £10,000, so you will record the transaction as a credit in the liability account.
EBITDA is an acronym for earnings before interest, taxes, depreciation, and amortisation. Whilst you may be unfamiliar with this financial term, EBITDA is a useful formula for understanding the financial health of your business, and its ability to generate cash flow.
To work out EBITDA, you need to add interest, taxes, depreciation, and amortisation back to your net profit (earnings). There are two formulas that you can use:
- Net Profit + Interest + Taxes + Depreciation + Amortisation = EBITDA
- Operating Profit + Depreciation + Amortisation = EBITDA
This metric can provide a quick estimate of your firm’s value and profitability. It’s also ideal for comparing the financial performance of your business against that of its competitors, as well as assessing whether it can repay its debts.
15. Financial year
A financial year, or fiscal year, is a 12-month accounting period that organisations, businesses, and individuals use for financial and tax reporting purposes.
Most self-employed sole traders and partners in business partnerships align their financial year (or ‘accounting period’) with the official tax year, which runs from 6 April in one year to 5 April in the following year. This makes things easier when preparing Self Assessment tax returns and working out personal tax liability.
If you run your business as a limited company, your financial year is determined by the date you set up your company. However, you can also change your financial year after incorporation by shortening or lengthening it. At the end of each financial year, you need to prepare annual accounts for Companies House and HMRC.
16. Gross profit
Gross profit is the financial gain that a business makes on the goods or services it sells. It is the difference between what the goods and services are sold for, and what it costs the business to produce and sell them (e.g. materials and labour costs).
The formula used to calculate gross profit is:
- Total Revenue – Total Cost of Goods Sold (COGS) = Gross Profit
Gross profit is incredibly important, because it shows the profitability of individual products and indicates whether your purchasing, production, and pricing strategies are providing a return.
Liabilities are expenses and debts that your business owes to other parties. The term can refer to huge debts like mortgages and business loans, as well as regular expenses such as tax bills, staff wages, rent, utility bills, and supplier invoices.
18. Net profit
Net profit, also known as net income or the ‘bottom line’, is all business income minus all costs and expenses associated with running the business. The amount that you are left with is net profit.
This differs from gross profit, which is based only on sales revenue and the direct costs of producing and delivering the goods or services sold. Net profit, by contrast, shows the profitability of the business as a whole, and includes a deduction for your overheads and fixed costs such as salaries, rent, software and bank charges.
19. Profit and loss account
A profit and loss account is an important financial report that summarises how much a business has spent and received over a specified period (usually one year), and whether it has made a profit or loss during that time.
Limited companies are legally required to include a profit and loss statement in their annual accounts when they file a Company Tax Return with HMRC.
20. Profit margin
Profit margin is a measure of how much profit a business (or particular business activity) generates. It is expressed as a percentage rather than a monetary amount. The higher the percentage, the greater the profitability.
To calculate profit margin, you need to divide profit by revenue (sales). For example:
- Your business made £35,000 net profit in a year
- Revenue for the same year was £50,000
- The profit margin is (£35,000 / £50,000) x 100 = 70%
It is common for businesses to analyse gross profit margins (to work out the profitability of specific products or services), as well as the net profit margin (to work out the profitability of the business as a whole).
21. Single-entry bookkeeping
Best suited to small businesses, single-entry bookkeeping records each transaction only once – either as income or an expense. This is far simpler than the double-entry system, which records every transaction twice (as a debit and a credit).
Single-entry bookkeeping is a straightforward way of keeping track of business income and expenditure in one account, so it is ideal if you are just starting out, or have only a small number of transactions to record.
Solvency is the ability of a business to meet its financial obligations over the long term and continue operating for the foreseeable future.
Your business is solvent if it has more assets than liabilities (debts). If it is unable to cover its long-term debts as they become due, your business is at risk of insolvency.
Turnover, also referred to as income or gross revenue, is the total amount of money that a business makes in a specific period, before the deduction of expenses, tax, and other costs.
It should not be confused with profit, which is the money that is left after all business costs, liabilities, and expenses have been deducted from turnover.
24. Working capital
Working capital (or net working capital) is the amount of money that your business has available to pay for day-to-day expenses within the current financial year. It is the difference between your current assets and current liabilities on the balance sheet.
25. Year end
The term ‘year end’ simply refers to the end of a company’s financial year. It represents the date to which accounts are made up to.
For example, if your year end is 31 March, your accounts will cover the financial year of your business up to and including 31 March.
If you run a limited company, the year end is also referred to as the accounting reference date (ARD).
Thanks for reading
Financial terms and accounting processes may not be the most thrilling of topics, but a basic understanding of these aspects of business ownership is vitally important.
To enhance your knowledge further and give your business the best chance of success, undertaking a bookkeeping and accounting course may be worthwhile. You can find these online and at local colleges or training centres.
Post a comment below if you have any questions about this post, and be sure to check out the Rapid Formations Blog for more business guidance and insights.