Learn the Language of Business: Understand Accounting

June 20, 2024
Accounting blog: Learn the Language of Business: Understand Accounting

The Language of Business

You’re on a ship in the middle of the ocean. The wind is howling, there’s a storm ahead, the ship is spinning in circles, and there’s no land in sight—you’re the captain. You try to read your compass, your map, or any other navigational instruments, but you can only vaguely interpret the symbols on them. The entire crew is running around trying to man their stations; you’re being pelted with questions left and right, but you can’t make out what anyone is saying.

You draw on all your prior experience and limited expertise as a former crewmember, and you try giving orders, but it’s clear from their vacant expressions no one else can understand a word you say either. A wave of dread and realization crashes into you: You don’t know the language, and your ship is going to sink.

Now, imagine running a business without understanding the language. The result will be the same. Accounting, often referred to as the language of business, is essential for translating the complex financial activities of a company into understandable information. Just as language tells the story of a culture (or a ship lost at sea), accounting tells the story of a business—how money flows in, flows within, and flows out of the business, all in pursuit of profit.

 

The Inflow: Where the Money Comes From

The first part of any good story is understanding where it all begins. For businesses, this beginning is the inflow of money, which can come from various sources.

Equity: Think of equity as the protagonist’s initial investment. When the business owner or investors put money into the company, it becomes equity. This money is used to get the business off the ground and to finance initial operations. For example, if Jane starts a bakery and invests $50,000 of her own money, that $50,000 is equity.

Loans: Sometimes, equity isn’t enough, and businesses need a sidekick. This is where loans come in. Loans are borrowed funds that the business promises to pay back over time with interest. Imagine Jane’s bakery needs an additional $20,000 for a new oven. She takes out a loan from the bank. This loan is another source of inflow, but unlike equity, it comes with a repayment obligation.

Revenue: Once the business starts operating, it earns revenue. Revenue is the money earned from selling goods or services. For Jane, revenue comes from selling her delicious pastries and bread. Revenue is the lifeblood of the business and the primary source of inflow that sustains operations over the long term.

 

The Movement: Money Within the Business

Once the money flows into the business, it needs to be managed wisely. This is where financing of assets, research and development, and other capital expenditures come into play.

Financing of Assets: Assets are the resources the business uses to operate and grow. These include everything from cash in the bank to equipment, buildings, and inventory. For Jane’s bakery, assets might include the oven, ingredients, and the bakery shop itself. Properly financing and managing these assets is crucial for maintaining smooth operations and effectuating the efficient inflow of revenue.

Research and Development (R&D): In any business, innovation is key to staying competitive. R&D involves investing in new products or improving existing ones. Suppose Jane decides to experiment with gluten-free recipes to attract more customers. The money spent on ingredients, testing, and refining these new recipes is an example of R&D.

Capital Expenditures: These are long-term investments in the business. For Jane, purchasing a new oven or renovating the bakery shop are capital expenditures. These investments are essential for business growth and efficiency, but they require careful planning and financing.

 

The Outflow: Where the Money Goes

Just as money flows into and within the business, it also flows out. This outflow includes liabilities, taxes, salaries, contractor payments, and other expenses.

Liabilities: These are the financial obligations the business must meet. Liabilities include loans, accounts payable, and other debts. Remember Jane’s loan for the new oven? The repayments she makes are considered liabilities. Managing liabilities effectively is crucial to maintaining the business’s financial health.

Taxes: Every business must pay taxes. These include federal, state, and local taxes on income, sales, and property. Proper tax planning and compliance are essential to avoid penalties and ensure the business remains in good standing.

Salaries and Contractor Payments: Employees and contractors are vital to the operation of any business. For Jane’s bakery, this includes paying the bakers, cashiers, and delivery drivers. These payments are regular outflows that need to be managed to keep the business running smoothly.

Other Expenses: This category includes all other costs of running the business, such as utilities, rent, marketing, and supplies. For Jane, this might mean paying the electricity bill, purchasing flour and sugar, or running an advertising campaign.

 

The Pursuit of Goals: Profit and Beyond

Ultimately, all these financial activities aim to achieve the business’s goals. While profit is the primary goal for most businesses, there can be other objectives as well.

Profit: The fundamental goal of any business is to generate profit. Profit is the difference between revenue and expenses. For Jane, profit is what’s left of her revenue inflow after paying for ingredients, salaries, utilities, and other costs. This profit can be reinvested in the business, saved, or distributed to owners and investors.

Growth and Expansion: Many businesses strive for growth and expansion. For Jane’s bakery, this might mean opening new locations or adding a delivery service. Achieving these goals requires careful financial planning and reinvestment of profits.

Social and Environmental Goals: Some businesses also have social or environmental goals. Jane might aim to source organic ingredients or support local farmers. While these goals may impact profits, they can enhance the business’s reputation and customer loyalty.

 

Telling the Story: Financial Statements

Just as a language uses words and sentences to tell a story, accounting uses financial statements to convey the business’s financial story.

Income Statement: This statement (sometimes called the Profit and Loss Statement, or P&L) shows the business’s revenue and expenses over a specific period, revealing the profit or loss. It’s like a detailed chapter in the business’s financial story, showing how well the business performed over that period of time.

Balance Sheet: The balance sheet provides a snapshot of the business’s assets, liabilities, and equity at a specific point in time. It’s like a summary of the business’s financial position, showing what the business owns and owes right now.

Cash Flow Statement: This statement tracks the flow of cash in and out of the business. It’s like the plot of the story, detailing how money moves through the business. Tracking the cash flow of a business is more important than you might think. Most of the figures on the Income Statement and Balance Sheet reflect cash value, but they are not liquid cash.

Even if you show significant profit on your Income Statement, much of your revenue might accounts receivable, or you may have dropped a lot of cash on prepaid expenses. Although technically “profitable,” you might not have enough cash on hand to make good on your liability payments or to cover other necessary expenses to keep your operations moving. The Cash Flow Statement tells you exactly where the cash flows from, where it flows out, and how much you have pooled and available right now.

 

Speaking the Language

Understanding accounting is essential for any business owner. It allows you to see the full picture of your business’s financial health and make informed decisions. Just as learning a new language opens up new opportunities, mastering the language of accounting can fully realize the potential of your business.

Learning a new language can be extremely difficult and overwhelming. When we encounter a language we do not understand well, we often need assistance from scribes, interpreters, and native speakers who also know our own language well enough to explain and clarify certain words or phrases. In the world of business, your scribes and interpreters are your bookkeepers, accountants, payroll specialists, tax preparers, etc. These experts in speaking the accounting language are there to help you understand your business’s story that is being written in and conveyed through the financial statements.

Whether you’re a small business owner like Jane or managing a large corporation, take the time to learn the language of accounting, engage with your interpreters, and understand your financial story. By doing so, you’ll be better equipped to right the ship, navigate the business world, conquer your goals, and write your own success story.

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