Accounting Lessons – Basic Accounting Help

What is the Working Capital Turnover Ratio?

spencergregory — Mon, 29 Mar 2021 22:34:51 +0000

A company’s working capital and cash flow can tell you a lot about a business. The working capital turnover ratio measures how efficient a company is using its working capital in relation to a given level of sales which tells a lot about a company’s financial situation at the end of the period. In other words, it’s a snapshot of how efficient a company is at generating net annual sales. This is also known as net sales to working capital.

Advantages of working capital turnover ratio

The most obvious advantage of the working capital turnover ratio is that it gives business owners a very clear snapshot of how the company is operating and how well your competitors are doing. Other companies’ turnover ratios offer a good benchmark to measure how well you are doing compared with other businesses in the same trade. All of this can give you a competitive edge in the market. It should indicate that money is flowing smoothly in and out of your business meaning that you will likely avoid any financial trouble and that you will have a sufficient amount of inventory to avoid any shortages in the near future.

Disadvantages of working capital turnover ratio

It is more of a disadvantage to have a low working capital turnover ratio than it is to have a high ratio. With a low ratio, you could possibly run out of money to operate your business and suffer a total collapse of your business. However, if the working capital turnover is too high, you may not have enough working capital and need additional capital to support growth in the future which may lead to a company becoming insolvent.

Importance of Working Capital Turnover Ratio Calculation

The working capital turnover ratio calculation gives you a snapshot of how efficient your company is operating based on its working capital and sales. Working capital consists of a company’s current assets and current total liabilities.

What is the Working Capital Turnover Ratio Formula?

To understand the formula, first you need to know what working capital entails. Working capital involves current assets and current liabilities which can be found on the balance sheet. Working capital is equal to current total assets minus current total liabilities. To calculate the working capital turnover ratio, divide net sales by working capital. The calculation is typically made on an annual basis and uses the average working capital during that time period.

Net Sales ÷ (Beginning working capital + Ending working capital)/2

Example of the Working Capital Turnover Ratio

A particular company or lets say company A has $100,000 of net sales during a 12-month basis and an average working capital of $25,000 during that period. The working capital turnover ratio would be calculated as follows:

$100,000 Net Sales ÷ $25,000 Average Amount of Working Capital = 4.0 Working Capital Turnover Ratio.

How Do You Interpret Working Capital Turnover Ratio?

The companies working capital turnover ratio will tell you if your working capital turnover ratio is low, high or too high. A lower working capital turnover ratio indicates that there are too many accounts receivable and inventory asset amounts to support a healthy amount of sales. This could lead to bad debts and inventory write-offs which may lead to financial trouble. A higher working capital turnover ratio indicates that a company is efficiently using its short-term assets and liabilities to generate gross sales. A working capital turnover ratio that is too high could mean that the business does not have enough capital for future sales growth. This is an indication that the accounts payable is creeping upwards and that the company’s ability to pay its bills may be at risk.

What Is A Good Working Capital Turnover Ratio?

A high working capital turnover ratio reveals that the business is being very efficient with the firm’s short-term assets and short-term liabilities when factored in with sales revenue. A high turnover ratio indicates your company is running smoothly and that additional funding or resources are not necessarily needed.

What Does Working Capital Ratio Tell You?

Working capital ratio tells you how efficiently your business is being run. How well are you managing and controlling your short-term assets and short-term liabilities in comparison to sales.

What Does A Low Working Capital Turnover Ratio Indicate?

A low working capital turnover ratio indicates that the company needs to keep an eye on the accounts receivable and inventory. Somewhere along the line, the company has collected too many accounts receivable and invested in too much inventory to balance out their sales. As a result, this could lead to an excessive amount of bad debts and outdated or obsolete inventory. Eventually, the inventory assets become a loss that have to be written off. Negative working capital means that the current liabilities exceed the current assets and immediate action for additional funds is needed.

What is the Statement of Cash Flows Direct Method? | Formula & Example

spencergregory — Mon, 29 Mar 2021 22:29:22 +0000

What is the Statement of Cash Flows Direct Method?

Cash flow refers to the amount of cash flowing in and the amount of cash flowing out of a business. These financing activities are reported on financial statements known as income statements. There are two methods that are used to report cash flow. They are the direct method and the indirect method.

Also known as the income statement method, the statement of cash flows direct method is a detailed statement showing where cash is coming from or cash inflows and where it is going also known as cash outflow.

Direct Method vs. Indirect Method

The indirect method used in calculating cash flow from operations starts with the net income from the income statement and uses adjustments to convert the income into cash flow. The direct method only takes into consideration the cash transactions and details the cash flow from operational activity. The direct method focuses only on cash received and cash paid. The indirect cash flow method takes into account the non-cash transactions from the balance sheet accounts.

When To Use Each Method

The direct and indirect methods are both used to calculate net cash flow. Both end up with the same result. The difference is how each are calculated and what sources are used to get that result. The indirect method details why the net profit is different from the bank’s closing figure. These differences are spelled out through the adjustments. The indirect method is used to determine investment potential. The direct method captures insight as to where the cash originated since it is real cash moving in and out of your bank account. This comes in handy for analysis purposes and cash management, especially if you are trying to identify problems related to cash or opportunities as well. It also is a good tool to use for cash flow forecasting. The indirect cash flow will tell you what happened and the direct cash flow tells you why it happened.

Advantages and Disadvantages of the Direct Method

The direct method is easier to calculate because it only uses cash transactions to produce the cash flow statement while the indirect method starts with the net income and adds non-cash expenses to create the cash flow statement. One advantage to the indirect method is that net income is automatically converted into cash flow while with the direct method, a reconciliation of net income must be done to separate the cash flow. The cash flow statement produced with the direct method is extremely accurate since there are no adjustments while the cash flow statement using the indirect method is not as accurate since there are adjustments being made. Another disadvantage to the direct method is that it takes more amount of time to prepare and is more complex, especially for larger businesses with a large amount of cash receipts and cash payments from various origins. Also, all of these transactions affect not one but two accounts. More companies tend to use the indirect method for this reason. Very few companies use the direct method even though it is recommended by the Financial Accounting Standards Board (FASB).

Formulas of the Direct Method

Here are the formulas for the direct method if accounts receivable is used for credit sales and accounts payable is used for credit account purchases.

1. Cash Received from Customers = Net Sales + (Beginning Accounts Receivable – Ending Accounts Receivable).

2. Cash Paid to Suppliers = Purchases + (Ending Inventory – Beginning Inventory) + (Beginning Accounts Payable – Ending Accounts Payable).

3. Cash Payments to Employees = (Beginning Salaries Payable – Ending Salaries Payable) + Salaries Expense.

4. Cash Paid for Operating Expenses = Operating Expenses + Increase or Decrease in Prepaid Expenses + Decrease or Increase in Accrued Liabilities

5. Cash Interest Payments = (Beginning Interest Payable – Ending Interest Payable) + Interest Expense.

6. Cash Payments for Income Taxes = (Beginning Income Tax Payable – Ending Income Tax Payable) + Income Tax Expense.

The total of all of these reflect the net cash used in operating activities.

How do you prepare a direct cash flow statement?

The direct method starts with a list of operating cash receipts such as cash collected from customers as well as interest and dividends received and cash payments such as cash paid to employees and cash paid to suppliers in the operating activities section of the cash flow statement. Also, in this section are any interest paid on outstanding debt as well as all income taxes paid. The result is cash from revenue minus cash payments for expenses which ultimately produces the net cash flow from operating activities.

Example of a Cash Flow Statement Direct Method

CASH FLOW FROM OPERATING ACTIVITIES:

Cash Receipt from Customers $1,000,000

Wages and Salaries (400,000)

Cash Paid To Vendors (450,000)

Interest Income 150,000

Income Before Income Taxes $300,000

Interest Paid (100,000)

Income Taxes Paid (125,000)

NET CASH FROM OPERATING ACTIVITIES $75,000

Bad Debt Expense: What is it and How to Calculate

spencergregory — Thu, 01 Nov 2018 03:42:12 +0000

When a company sells products and services, it may do so by extending credit to its clients. When a company produces products or services for customers and issues invoices for payment of those products or services, it is reasonable to assume that many of those invoices will not be paid. As a result, an accounts receivable is created and left open, until the money is collected. If the money is never collected and the client defaults on their obligation, then the receivable needs to be removed the balance sheet.

Unpaid receivables like these become and will need to be recognized on the income statement, to reflect the loss the company experienced. The amount of bad debt expense record is contingent on US GAAP.

How to Calculate the Bad Debt Expense Formula

When a business is owed money, and clients fail to pay, there are losses that need to be recognized on the income statement. Bad debt expense is recorded using a technical accounting method, such as the direct write-off method or the allowance method. Selecting the right method, and making the right calculation, impacts the relevance and accuracy of a company’s financial statements.

Learning how to calculate can be handled a couple of different ways. The first is the method which simply credits the potential in . Since is part of the , it does not affect the . Instead, a is made under the for category, and a is issued to Accounts Receivable.

The for helps to estimate the a company believes it will receive. It is considered a , and is only used by companies that allow customers for payment of goods and services. The must reflect the same period in which a particular sale was made and can be adjusted depending on the amount left in the .

The for can be estimated by applying a flat rate to or by using historical aging data. Under the first process, also known as the method, a company that grosses $100,000 in a reporting period could estimate that three percent of their total will not be collected. Therefore, an for would be established with a balance of $3,000.

Using the aging method, all unpaid debts are categorized by time periods. For example, a company divides debts by 30 days outstanding and 60 days outstanding. By reviewing historical data, a company could determine that two percent of accounts 30 days old or less are typically unpaid, and five percent of accounts 60 days or older go unpaid. The company would report an for that is the total expected unpaid debt amounts for both categorized periods.

The second method for calculating is to use a simple direct write-off. To determine how much should be written-off, a company would take the real number of uncollected debts and divide by the total during that period to obtain a rate. This rate would show the of bad debt.

The accuracy of bad debts in is a bit tricky. Companies cannot be certain that a debt will never be paid. Therefore, they have to estimate what they believe will be uncollected debt based on past collection data. The longer a company is in business the more accurate the bad debts expense estimation can be because there is a longer aggregate history to consider.

Factors Impacting Bad Debt

There is a myriad of factors that can change the likelihood and volume of bad debt. For example, severe economic downturns can give rise to higher default rates and uncollectible accounts receivable. Other factors include loose lending criteria, industry specific crises and customer dissatisfaction. Forecasting bad debt volumes is a process that auditors and business owners both care about, making it important for accountants, analysts and business leaders to make accurate predictions.

Preparing Bad Debt Expense Journal Entry

When preparing a bad debt journal entry, it is important to have the bad debt schedule and write-off policy as supporting documentation. The journal entry requires the reduction of accounts receivable and the recognition of bad debt expense on the income statement. The type of journal entry created, and support used varies between the direct write-off method and the allowance method. Expect to have this journal entry audited during financial examinations.

Examples of Bad Debt Expense

When a company has accounts receivable, and some of the accounts are uncollectible, bad debt expense is recognized and recorded in the proper amount. The bad debt can result from defaults on notes receivable, trade receivables arising through the normal course of business or another type of receivable. The direct write-off method allows for a straightforward calculation and write-off of bad debt. The allowance method, however, is more complicated to record.

Bad debt expense is a widely monitored metric in the mortgage industry. Given that defaults on mortgages gave rise to one of the worst financial crises in U.S. history, the allowance for bad debt is something that regulators and investors focus on. It is important to accurately forecast bad debt and prepare for it from a cash flow perspective, to protect the health of a business.

Calculating bad debt expense accurately is of the utmost importance to users of financial statements. Selecting the right calculation method, and maintaining accurate supporting schedules, requires skill, vigilance and dedication. Working with trained accountants is critical for recording bad debt accurately.

For companies that choose not to establish a bad debt which allows a to write-off , there could be real consequences. Many business owners and managers have a difficult time believing a client won’t pay their . Unfortunately, even customers who have a wonderful payment history could encounter a problem which prevents them from being able to pay, and companies must be prepared to withstand these bad debts. Failing to create a bad debts , especially when is growing, will have a direct affect on financial planning efforts. Managers could end up with less money than projected and find themselves unable to meet their own obligations. The omission of the bad debt can also prevent management from having a true understanding of the financial health of the company.

Using financial statements as a monitoring tool, a business may find their bad debt expenses are higher than normal and becoming problematic, it could be time to review policies on extending credit to clients. An evaluation of these procedures could make a tremendous difference in the bottom line of a company in a very short period of time.

Basic Accounting Concepts

spencergregory — Sun, 23 Apr 2017 02:50:36 +0000

Lesson 1 in the Basic Accounting series:

Understanding basic accounting concepts is a must for every small business owner.

Even if you have an accountant that takes care of that “accounting stuff”, you need to know business accounting basics such as debits and credits and some accounting terminology.

Accounting is setting up a system of recording and summarizing financial transactions in such a way that they can later be analyzed or used to communicate with others.

Foundation of Basic Accounting Concepts:

The basic accounting equation is the foundation of all basic accounting concepts.

The financial position of all companies both large and small, while similar, are calculated slightly differently depending on the business entity:

For sole proprietorships: Assets = Liabilities + Owner’s Equity

For corporations: Assets = Liabilities + Stockholders’ Equity

Assets are what a company owns
Liability accounts are what a company owes
Owner’s Equity or Stockholder’s Equity is the difference between total assets and liabilities.

Learn more about accounting basic terms.

An example of this accounting equation for a small business owner:

You buy a computer (an asset) for $5,000. If you borrowed $3,000 (a liability) and paid the balance with your savings, here is what the accounting equation would look like: $5,000 computer (asset) = $3,000 loan (liability) + $2,000 (owner’s equity) in the computer.

Recording Basic Accounting Transactions: There are two basic ways to record your financial transactions: single-entry bookkeeping and double-entry bookkeeping. See what the difference is between the two on this page: Double-Entry Bookkeeping vs. Single-Entry Bookkeeping. Most businesses use the double-entry accounting system. In this system, every business transaction is recorded in at least two business accounts. Write a big T on a piece of paper. Above the left arm of that T write Debit and above the right arm write Credit. We are going to use this T account as a visual aid to see how debit and credit work with your accounts. Now imagine you were paid $100 for your one-of-a-kind thingamajig. To record this business transaction in the general ledger of a double-entry system, you would debit your Cash account by recording it under the left arm of that big T you drew and credit your Sales (Revenue) account by writing it under the right arm of that T–under the Credit heading.

Getting these transactions right, will make a huge impact on your financial statements; such as the income statement, cash flow statement or statement of cash flows, and balance sheet. The financial statements are powerful tools to calculate the financial ratios that are used to evaluate the financial performance of a business.

Accounting Basics Tips:

Debit just means left

Credit just means right

Debits and Credits must always equal!

To determine how you would record the transaction you have to determine what kind of account is being affected and if it was increased or decreased.

In the above example, Cash is an asset account and we increased our cash with the sale, so looking at the chart below, you see that to increase our asset account, we would need to record it on the Debit side (left side).

We also increased our Sales Revenue, but since it is an income account we would need to record it on the Credit side (right side).

See how even though we increased both accounts–the debits and credits equal? That is the basic accounting concept of debits and credits.

When first learning about accounting, debits, and credits are very difficult to understand. Since more accounting is built off of the double-entry bookkeeping system, each entry will have a debit or credit and many people initially assume the word debit is the same as subtracting or an expense. In actuality, debit or credit will work differently depending on the financial statement. For example, debits increase assets and reduce liabilities on the balance and on the income statement, credits decrease expenses or increase revenue.

Debits And Credits Vs. Account Types:

Anytime an accounting transaction is created, there will be at least two accounts impacted. There will always be a debit entry and credit entry recorded and the totals of all of the debits and credits must be equal. Without a balance between debit and credits, financial statements would not be accurate.

As shown in the table below, the debit can either increase an asset or expenses and decrease a liability or equity entry, while a credit increases a liability or equity entry and decreases assets or expenses. Just remember the debit entry goes on the left and the credit goes on the right!

Account	Debit	Credit
Assets	Increases	Decreases
Liabilities	Decreases	Increases
Income	Decreases	Increases
Expenses	Increases	Decreases

Debits are sometimes noted as DR and credits as CR. Why is a debit called a DR and credit CR? There isn’t a solid answer, but it is widely believed that debit used to stand for debit record and credit as credit record and the DR and CR were shorthand notations.

Remember: Debits go on the left and Credits on the right!

Remember Debits go on the left and Credits on the right!

Note: Need more help remembering which account to debit and which account to credit?

See this page on basic accounting concepts for recording accounting journal entries for some sure-fire tips on debits and credits.

A Couple Of Pointers:

Although it is called a double-entry system, a transaction may involve more than two accounts.

For example to record a loan payment you would debit two accounts Notes Payable and Interest Expense. Then credit the total loan payment because we decreased our asset account Cash.

And …

Although I used the T account to illustrate how debits and credits work, most professional accountants use the format shown on this page: Accounting Journal Examples.

Notice you first show the account and amount to be debited. Then indent the next line and show the account and amount to be credited.

Accounting Principles

Several basic accounting principles have been developed that are the basic building blocks that form the basis for modern accounting or today what we know of as “Generally Accepted Accounting Principles” or GAAP.

Without these core principles and common practices, the reporting of accounting would be inconsistent and unreliable. Additionally, these core principles provide a standardized way to compare financial reports between companies.

Below are some of the core accounting principles

Accounting Period Principle – A business should report the results of its operations over a standard period of time, typically monthly, quarterly, or annually to make useful comparisons.

Accrual Principle – Under the accrual accounting method, all accounting transactions are recorded in the period when it is earned, rather than when cash was received from the customer. This also holds for expenses as they are recorded when they were incurred, rather than when they were paid.

Consistency Principle – Once a business adopts an accounting method or policy, that method or policy should continue to be used in similar situations, unless there are reasonable reasons. Not following this principle means useful comparisons of financial statements over multiple accounting periods cannot be made due to inconsistent data being used

Cost Principle – A business should record its fixed short and long-term assets at the original cost and not fair value at the time of acquisition minus accumulated depreciation.

Economic Entity Principle – A business is considered a separate entity from its owners and should be kept separate from the business.

Full Disclosure Principle – All non-standard financial information or notes are disclosed in the financial statements to allow a reference point.

Going Concern Principle – Stipulates that a business is expected to continue indefinitely and assets are not intended to be sold immediately or liquidated.

Matching Principle – When revenue is recorded all related expenses are recorded in the same period to provide an accurate picture of the profitability of the business.

Materiality Principle – Errors or omissions of financial accounting procedures that involve immaterial or small amounts may not need attention or correction as they would not alter business decisions.

Monetary Unit Principle – Business transactions that are recognized as monetary currency are only recorded in a business’s accounting records.

Reliability Principle – Only those transactions that have supporting documentation like a receipt and are accurate and unbiased should be recorded.

Revenue Recognition Principle – Revenue is only recognized only when it is earned.

Important Definitions

Some common basic accounting terms that you will likely come across when learning accounting concepts include:

Accounting Cycle – The accounting cycle refers to the process steps that are taken to close the books and generate financial statements.

Accounts Payable – Also referred to as A/P, accounts payable is a record of bills that have been entered into a ledger or accounting software, but have not yet been paid.

Accounts Receivable – Also referred to as A/R, accounts receivable are the revenue a company has made to customers but has not yet collected payment on.

Accrual Method – The accrual method of accounting recognizes revenue and expenses on the day the transaction takes place, not when payment is received as in the cash method.

Book Value – Book value refers to the value or net worth of a company if it liquidated all of its assets and paid back all liabilities.

Burn rate – The burn rate is a measure of how quickly a business is spending its cash reserves.

Cash Method of Accounting – Cash basis accounting or sometimes called cash accounting refers to income being recorded when customers pay (and not as sales are made as in accrual accounting) and expenses being recorded in the period in which they are actually paid. Learn more about the difference between cash accounting and accrual accounting.

Chart of accounts – The chart of accounts lists all of the accounts found in the general ledger, which is where all of your accounting entries reside.

Cost of Goods – Cost of Goods Sold (or COGS) are the expenses that directly relate to the cost of producing a product or delivering a service.

Current Assets – Current assets are assets that will be converted to cash within one year.

General Ledger – The general ledger is the record-keeping system for a company’s financial data.

Fixed Cost – A fixed cost is a cost that does not change regardless of how many sales are made, Common examples are things like labor or rent.

Gross Margin – Gross margin, better known as profit, is sales minus any costs associated with creating the product or service, divided by revenue.

Gross Income – Gross income, also known as gross profit is calculated by taking total revenue and subtracting the cost of creating the product.

Journal Entry – Journal entries are a summary of a transaction and are how updates and changes are made to a company’s books.

Net Income – Net income, or net profit, is the revenue earned in a specific time period. Net income is calculated by taking revenue and subtracting all expenses such as COGS, operating expenses, depreciation, and taxes.

Present Value – Present value is the current value of a future sum of money based on a specific rate of return.

Stockholders’ Equity – Stockholder’s equity, sometimes referred to as owner’s equity is the money invested by the owners into the company.

Trial Balance – The trial balance is recorded at the end of an accounting period in the general ledger.

Variable Expense – A variable expense is one where the amount changes (or varies) in proportion to the change in volume. Common examples include labor, commissions, or raw materials.

Working capital – Working capital is calculating current assets and subtracting current liabilities.

Next Section: Lesson 2 – Double Entry Bookkeeping

Double Entry Bookkeeping

spencergregory — Sun, 23 Apr 2017 02:49:48 +0000

Lesson 2 in the Basic Accounting series:

With a double entry bookkeeping system every one of your small business transactions will be recorded into at least two of the accounts in your accounting system.

Is double entry accounting right for your small business or will another accounting system work better?

Single Entry vs Double Entry Bookkeeping:

There are two basic ways to record your financial transactions:

Single entry bookkeeping can used by small businesses where a balance sheet is not required for financial control or tax purposes.

Double entry bookkeeping is required for all businesses that must produce both a profit and loss account and a balance sheet.

To decide if a single entry or double entry system would be best for your business…consider the type of business you own.

A small sole proprietorship or home-based business may not require a double entry system for recording business transactions.

However, if you have quite a few accounts receivable (money owed to your business by your customers) or accounts payable (money owed by your business), you may want to consider utilizing a double entry system.

Most small business owners do not usually start right out with a double entry system.

It is easier for them to use a single entry method which is kind of like your check register. You just add the money coming in and subtract the money going out and keep a running balance.

There are pros and cons of using a single entry bookkeeping system.

The main selling point is the simplicity of single entry bookkeeping.

You just have two lists–one for income and one for expenses.

The main disadvantage of single entry bookkeeping is its limited ability to track your assets (what your business owns) and liabilities (what your business owes.) It is also easier to make errors with. With double entry bookkeeping everything must balance.

I have built my free accounting spreadsheets using the single entry bookkeeping system mainly because the double entry system would be too complicated for me to build and give away and secondly because I had built these spreadsheets in the first place for several small business owners that did not have any prior accounting skills.

Double Entry Bookkeeping Advantages:

Most medium and large businesses use a double entry system which tracks their income and expense AND their assets and liabilities.

Double entry accounting is require for all businesses that are required to produce a statement of its assets and liabilities (a balance sheet).

In a double entry system, at least two entries are recorded with each business financial transaction…a debit and credit. Each transaction must balance each other. See more details about basic accounting concepts such as debit and credits.

Take for example the purchase of the computer for your small business. In a single entry system, you would simply subtract the purchase price from your running total.

In a double entry system you would debit your asset account (Office Equipment or whatever you named it) and credit either cash or accounts payable…depending on how you paid for it. See why a double entry system is best for tracking assets and liabilities?

Note: If you use small business accounting software you probably will not see that two or more accounts are being affected. All that fun double entry accounting stuff is done behind the scenes for you.

For example if you record a check you wrote for that computer we were talking about above, your accounting software will automatically reduce your Cash account and only ask you for the other accounts affected such as Office Equipment.

See this page for some tips on picking out an affordable user-friendly double entry bookkeeping system.

Next Section: Lesson 3
Recording Accounting Journal Entries

Previous Section: Basic Accounting Concepts

How to Record Accounting Journal Entries

spencergregory — Sun, 23 Apr 2017 02:48:51 +0000

Lesson 3 In The Basic Accounting Series:

Learning how to record accounting journal entries is the foundation of any business accounting course. Let us show you the steps and some examples!

If you are a student, small business owner, or just wanting to brush up on your accounting skills, understanding the basic accounting concepts of debits and credits and double-entry accounting will be the first step you want to take in building your accounting skills.

What Is A Journal Entry?

A journal entry is the primary record of all financial transactions of a business in chronological order. Before computer accounting software programs, the process of recording transactions was manual and recorded in a paper journal and is where the term journal entry comes from.

What Are Journal Entries Used For?

Journal entries are used to record daily financial transactions to analyze how financial transactions impact a business

The journal entries are aggregated to the general ledger which is then used to construct financial statements such as loss statements, balance sheets and cash flow statements.

What Is In A Journal Entry?

A journal entry should typically include:

Unique identifying number of the entry
Date of the transaction
Amount(s) to be debited and credited
Account(s) where the debits and credits are recorded
Name of the person making the entry
Whether the entry on one-time or recurring
A description of the transaction may be beneficial to include and provide information regarding the entry

Here are some examples of accounting journal entries.

Now that we have the basics, let’s go step-by-step through the accounting cycle of double entry journal entries.

Step 1 – Recording Accounting Journal Entries With Debits And Credits:

In a double entry accounting system (used by most businesses) every business transaction is recorded in at least two accounts. (Learn more about double-entry accounting in our bookkeeping section)
One account from your small business chart of accounts will be debited which simply means the amount will be recorded on the left side and one account will be credited…amount recorded on right side.
Debits and credits must balance equal.
See more about debits and credits in our basic accounting concepts section.

Step 2 – Journalizing

Note: Today most accounting is done on computers and the journalizing (recording accounting journal entries) is done in the background; however, it is still important to know the basics of double entry accounting.

In manual accounting, each financial transaction is first recorded in a book called a journal.
In that accounting journal entry, the title of the account to be debited is listed first, followed by the amount to be debited. The title of the account to be credited is listed below and to the right of the debit, followed by the amount to be credited.
To determine which account is debited and which is credited you have to first determine what kind of account is being affected and if it was increased or decreased.

Step 3 – Recording Accounting Journal Entries Using The Accounting Equation:

To determine which account is debited and which is credited memorize this basic accounting equation (the foundation of all basic accounting concepts):

Assets = Liabilities + Owner’s Equity

Assets are on the left side or debit side and asset accounts such as Cash have their normal balances on the left side.
Liabilities and Owner’s equity are on the right side or credit side and their accounts in the general accounting ledger have their normal balance on the right side.

Okay…here’s where it gets a little complicated…but keeping the above equation in mind makes it a lot easier to understand:)

Step 4 – Recording Accounting Journal Entries: Increase Or Decrease?

To record a business transaction in an accounting journal entry, we need to look closely at the transaction and see which accounts it involves and if it increased or decreased those accounts.
If it involved an asset account such as Cash, you would picture that basic accounting equation above and know that its normal balance is on the left side (debit side), so if we received (increase) cash we would record the amount on the left side.
However, if it decreased our asset account such as paying our small business bills, we would record it on the second line and on the right side to show a decrease in that account.
If the business transaction increased our liabilities or owner’s equity we would record it on the right side ( credit side) because those balance sheet accounts have a normal credit (right) balance. (Remember that equation?)
If the transaction decreased our liabilities or owner’s equity we would record it on the left side ( debit side).
To sum it up—remembering the basic accounting equation: increase a balance sheet account by recording the amount on the same side as its on in the equation; decrease it by recording amount on the opposite side.
For income statement accounts such as revenue (income) and expenses, you just need to remember revenue accounts have a normal right credit balance. (Easy for me to remember—Revenue increases owner’s equity and has the same normal “credit” balance). There are single-step income statements and multi-step income statement templates available online that can be accessed via download that will reflect operating expenses, gross profit, operating income, net sales, non-operating revenues, gross margin, net operating income, non-operating expenses and non-operating income, all over a specific period of time.
So following the rules above—when you increase your revenue account, you would record the amount on its normal credit (right) side and to decrease it you would record the amount on the debit (left )side.
Expenses have a normal debit (left) balance. To increase your expense account, you would record the amount on its normal debit (left) side and to decrease it you would record the amount on its opposite (credit) side. Tip: Expenses are almost always debited! Expenses include such line items as licenses, bank charges, interest expense, postage, permits, professional fees, delivery expenses, vehicle expenses, credit card fees, freight, subscriptions and repairs.

Step 5 – Practice Recording Accounting Journal Entries:

The best way to learn something is to do it…so let’s study some examples of general journal entries using double-entry bookkeeping: Bob open their brand new store selling thingamajigs. Here are some examples of their basic accounting journal entries for the first accounting period:

Transaction #1 – Jane an Bob invest $15,000 into their new business; rent a building, and start selling their merchandise. How should the general journal entry be made?

Date	Account Names & Explanation	Debit	Credit
3/1	Cash	15000
	Capital		15000
	Jane and Bob deposit $15,000 in their new business bank account.
	Debit: increase in asset (cash)
	Credit: increase in owner’s equity
Transaction #2 – On March 5^th, the company paid their first month’s rent of $1,700. The expense is recorded by debiting it and deceasing cash by crediting it.
3/5	Rent Expense	1700
	Cash		1700
	Paid first month’s rent of $1700.
	Debit: increase in expenses (rent)
	Credit: decrease in asset (cash)
Transaction #3 – On March 10^th, the company purchased direct material for inventory that was worth $4,000 on credit. This will result in an increase in an asset account which is a debit and a credit to Accounts Payable in the amount of $4,000.
3/10	Thingamajig Material – Inventory	4000
	Accounts Payable		4000
	To make their thingamajigs Jane purchased $4000 in thingamajig materials on credit for cost of goods.
	Debit: increase in assets (inventory)
	Credit: increase in liabilities (AP)
Transaction #4 – On March 15, the company made sales of $2,200 and received $1,200 in cash and the remaining $1,000 as Accounts Receivable. This results in a compound journal entry. We will record an increase in cash and Accounts Receivable and debit those accounts. In addition, the Revenue account is credited by $2,200 even though full payment hasn’t been received.
3/15	Cash	1200
	Account Receivable	1000
	Revenue		2200
	Sales of $2200. Cash sales of $1200 and sold $1000 on customer credit. (Compound entry: Some transactions will affect more than one account)
	Debit: increase in assets (cash)
	Debit: increase in assets (AR)
	Credit: increase in Revenue
Transaction #5 – Also on March 15, an expense was made to purchase materials that will be used to create inventory for $600. As such there will be a debit in expenses and credit in inventory.
3/15	Thingamajig Material Expense	600
	Thingamajig Material – Inventory		600
	$600 in Thingamajig material was used to make more Thingamajigs.
	Debit: increase in expenses (Thingamajig Material)
	Credit: decrease in asset (inventory)

Transaction #6 – For this accounting entry, on March 28, the company paid some of its liability from Transaction #3 by issuing a check. To record this transaction, we will debit Accounts Payable for $1,800 to decrease it, then we will credit cash to decrease it as a result of the payment.
3/28	Accounts Payable	1800
	Cash		1800
	Paid $1800 on credit account.
	Debit: decrease in liabilities (AP)
	Credit: decrease in assets (cash)
Transaction #7 – On March 30 the company collected a portion of the amount due from the customer in Transaction #4. This transaction is recorded as an increase in cash by debiting it by $500. Then, we credit Accounts Receivable to decrease it, which will reduce the receivable since some of the money has been collected.
3/30	Cash	500
	Accounts Receivable		500
	Collected $500 in cash from credit customers.
	Debit: increase in assets (cash)
	Credit: decrease in asset (AR)

Notice how each transaction is balanced. Everything entered on the left hand (debit) side equals the (credit side) right hand side. That’s what double entry bookkeeping is all about—transactions must balance. It’s kind of like what you learned in basic algebra classes–if you can remember back that far – what you did to one side of the equation you had to do to the other side.

A couple of more tips on journal entry accounting:

The above accounting journal entries did not include account numbers. Usually in real life, you would use the account numbers from your chart of accounts to identify each account.
You do not use dollar signs in recording the amounts. If the journal is prepared in the United States the amounts are understood to be in the US Dollar.

Next Section: Lesson 4

Posting to the Accounting Ledger

Previous Section: Double Entry Bookkeeping

How to Post to Your Accounting Ledger

spencergregory — Sun, 23 Apr 2017 02:47:26 +0000

Lesson 4 In The Basic Accounting Series:

A general accounting ledger is a collection of your chart of accounts. It is where all of your general journal entries or financial transactions end up for the accounting period.

While spreadsheets can be used, most all accounting these days is done on with software, which makes it easier for the bookkeeper. Accounting software such as Quickbooks, Xero, Freshbooks, Wave and others do the posting to the general ledger accounts in the background for efficiency and accuracy. Financial statements such as the balance sheet and the income statement are both created from the general ledger. The account balances from the general ledger are also summed up to create a trial balance.

For example, say you record a check that you wrote to pay your rent in your accounting software.

In the background, your accounting software will automatically debit your rent expense account and credit your cash account…posting them to your accounting ledger.

However, it is important as small business owners or even someone just studying accounting to know how and why the accounting software did what it did and to fully understand the accounting system.

So I am going to give you a brief overview of how to post accounting journal entries to your general ledger.

First of all, if you haven’t read it, please read this page on accounting journal entries. It will tell you how to decide if an account should be debited or credited.

I am going to use those accounting journal entry examples to show you how to post them to an accounting ledger. So you might want to print that page out first and then come back to this page…or I have the above link to the accounting journal entries opening in another window if you just want to have both pages up at once.

Posting To An Accounting Ledger:

As you can see, Jane and Bob have recorded their business transactions for the first month of business. Now it is time to take those accounting journal entries and transfer the debits and credits from the journal entries to the appropriate accounts in the general accounting journal.

This is called posting.

Remember, an accounting ledger is a group of accounts from your chart of accounts.

Here is an example of posting some of Jane and Bob’s journal entries that involved cash to the Cash account in their accounting ledger. It is always helpful to keep the accounting equation in mind when posting debit amounts and credit amounts. This is also known as the double-entry bookkeeping method.

Cash-101

Date	Description	Debit	Credit	Balance
March-1	Balance forward from Feb-28	0
3/1		15000
3/5			1700
3/15		1200
3/28			1800
3/30		500
3/31	Balance	13200

The title contains the name of the account and its reference number from your chart of accounts.

The first column is the date. Fill in the date of the transaction.
The second column is the item. (It is not necessary to write out a description unless you just want to.)
The third and fourth column is the debit and credit columns. Debit entries are entered on the left side or debit side, while credit entries are entered on the right side or credit side.
The fifth column is the balance column. Some keep a running total, but most draw a line underneath the entries, net all the entries together, and put the balance on the correct side (See explanation at the bottom of this page) of the account.

Summary of the example above:

The first line is the balance carries forward from the month before.
The second line is Jane and Bob’s contribution of $15,000 on March 1st to capitalize their business. (Increased cash – debit)
On the 5th, Jane wrote a check for $1700 for the lease on their store.(Decreased cash – credit)
On the 15th, they had cash sales of $1200. (Increased cash – debit)
On the 28th, Bob paid $1800 to their suppliers for material purchases made earlier in the month on credit. (Decreased cash – credit)
On the 30th, they received $500 from their credit customers (Increased cash – debit)

I just used this as an example. In real life, you would take each line from the accounting journal entries and transfer the amounts to the corresponding Ledger accounts.

*Notice where I put the balance. It is in the debit column. Each type of account will have a normal balance in either the debit or credit column depending on the category of the account:

Asset accounts like cash accounts receivable, land, and equipment have a debit balance.
Liability accounts have a credit balance.
Owner’s Equity has a credit balance.
Incomes have a credit balance.
Expenses, such as utilities and fees, have a debit balance.

Next Section: Lesson 5

Financial Statements

Previous Section: Recording Journal Entries

Understanding Financial Statements

spencergregory — Sun, 23 Apr 2017 02:46:39 +0000

Lesson 5 in the Basic Accounting series:

Understanding financial statements are one of the keys to your small business success because the statements are a reflection of the company’s financial performance and the company’s financial health.

Sadly, many entrepreneurs fail not because they lack knowledge of their products and determination…

but, because they failed to realize the importance of preparing and analyzing their financial statements and financing activities.

Analyzing And Understanding Financial Statements:

Financial statements are the main way to report financial information to people within your organization, such as management and employees, and to people outside your organization such as banks, investors & financial analysts, suppliers, and others. Investors and financial analysts will look at working capital, operating margin, and debt obligations to analyze the stability and future of the business.

For example, a small excavating company significantly increased sales for three straight years then failed. The reason why? They overspent on equipment and overextended themselves by offering loose credit terms and discounts.

You can avoid these cash flow traps by simply taking the time to analyze your financial statements by looking for financial trends.

The main three financial statements for small businesses are the Profit and Loss Statement (income statement), the balance sheet, and the statement of cash flows or cash flow statements.

The order in which the statements are normally prepared and the nature of the data presented in each statement are as follows:

Profit and Loss Statement (Income Statement) — a summary of the revenue and expenses for a specific period of time, such as a month or year including depreciation, amortization, operational expenses, net income, gross profit,
Accounting Balance Sheet — a list of the assets (current assets, long-term assets, intangible assets such as patents & goodwill, total assets), liabilities (current liabilities, short term liabilities, long term liabilities, total liabilities), accounts receivable, dividends, and owner’s equity and shareholders’ equity as of a specific date, usually at the close of the last day of a month or a year. This includes inventory,
Statement of Cash Flows — a summary of the cash receipts and cash payments for a specific period of time, such as a month or a year

All three financial statements should be identified by the name of your small business, the title of the statement, and the date or period of time.

The data presented in the profit and loss statement and the statement of cash flows is for a certain period of time. The data presented in the balance sheet is for a specific date.

Note: If you have a very small business, a profit and loss statement and a balance sheet are usually all that is required or needed.

Your retained earnings data, which shows your profits or losses from the first day of your business to the present are shown on your balance sheet in small businesses. In larger businesses, this data is detailed in a separate report called a Statement of Owner’s Equity.

A statement of owner’s equity a summary of the changes in the owner’s equity that occurred during a specific period of time, such as a month or year. It is also called a Retained Earnings Statement.

Understanding financial statements are not rocket science. Most small business owners have basic financial information on their financial statements. So learn basic accounting principles and gain a basic understanding of how to prepare and read financial statements.

Also, understand the importance of generating and analyzing financial statements and see what investing activities investors look for in your statements in this article: Financial Statements for a Small Business. Investing activity includes the cash flow from the purchases or sale of assets.

This information will help you with your day-to-day financial decisions in your business and help you in your quest for financial success.

Next Section: Lesson 6

Financial Ratio Analysis

Previous Section: Accounting Ledger

Financial Ratio Analysis

spencergregory — Sun, 23 Apr 2017 02:45:05 +0000

Lesson 6 in the Basic Accounting series:

Financial ratios and performing a financial analysis using your financial statements can help to construct a successful small business.

Financial Ratio – Comparative Analysis

Comparing your current financial statements to:

previous years
previous months
previous quarters

…can tell you how your business is doing financially and if it is fulfilling its obligations.

Are sales better or worse?
Are costs more or less (compare each expense)
Is your cash flow improving? What are your total current assets?

These are just a few of the things you will want to study in your financial analysis.

Pull out those previous financial statements, clear your calendar, get comfortable, and plan on spending a few hours analyzing and comparing those previous financial statements with your current ones.

Those of you with a new business can take your pro forma statements (Pro forma financial statements are forecasts of the financial position of a business at some defined point in the future) and perform your financial analysis by asking yourself the following questions:

Do you have fewer sales than you predicted…if so, why?…possibly due to trends?
Were any expenses greater than you predicted?…What is the total debt? Total current liabilities?
Is there a way to lower them? Perhaps the cost of goods?

Financial Ratio – Industry Comparisons

An industry comparison analysis compares your small business’s performance to other small businesses in your industry.

These are not as easy to do simply because finding the data you need to perform these financial analyses is sometimes difficult to find.

However, if you ever need a loan or investors, you can bet they will perform some of the following financial ratio analysis or with your financial statements.

So it may be worth a little effort and/or money to get your industry average ratios. I live close to a college, and usually, I can get a copy of industry averages free from the library there.

You might be able to find the same information at your local library. The books you want to look at are the Standard and Poor Industry Averages and the Valuline Surveys.

You can also get a basic financial ratio report in your industry free online from this site: bizminer.com, but you have to pay for a more current detailed report.

Here are a few of the most common financial ratio analyses using your Profit and Loss Statement or income statement.

Gross Profit Ratio – This is the most common ratio calculated on your Profit and Loss statement. You divide your gross profit by your net sales. Then compare your ratio to similar small businesses in your industry. Click here for a free Gross Profit Margin Ratio calculator.
Net Profit Ratio – This formula is simply Net (pre-tax) Profit divided by Net Sales. “Net Income” is income with all expenses subtracted out, including taxes, interest expenses, and depreciation. “Net Sales” is sales revenue minus any returns and allowances. This is a good ratio to perform a comparative analysis with. Look at your data historically to see how the net profit margin is trending.

Most financial ratios are calculated using your Balance Sheet.

Here are a few of the most common financial ratio analyses: using your Balance Sheet:

Current Ratio – This is the most common ratio calculated on your Balance Sheet. Bankers and investors use this ratio to determine if you are likely to be able to pay your bills. It is calculated by dividing Current Assets by Current Liabilities. An acceptable current ratio is at least 1:1, but a ratio of 2:1 would be much better. Click here for a free Current Ratio calculator.
Quick Ratio – Calculated by dividing the sum of Cash and Account Receivables by Current Liabilities. This ratio is often referred to as the “Acid Test” because it concentrates mainly on your more liquid assets. An acceptable quick ratio is 1:1. Click here for a free Quick Ratio calculator.
Debt/Assets Ratio: Total liabilities divided by total assets. The resulting ratio tells your banker, investors, and/or creditors what portion of your assets are paid for with borrowed money, so the lower, the better with this one:) Click here for a free Debt-to-Assets Ratio calculator.
Return on Assets – This is calculated by dividing Net (pre-tax) Profit by Total Assets. Bankers and investors use this one to determine how efficiently you are using your assets. Click here for a free Return on Assets Financial Ratio calculator.

These are just some of the ratios you can use to do a simple financial statement analysis. There are more complex ratios falling in various categories, such as efficiency ratios, net profit margin ratios, operating cash flow ratio, market value ratios, fixed asset turnover ratio, working capital ratio, dividend payout ratio for dividend yield, price earnings ratio, inventory turnover ratio, leverage ratios, receivable turnover ratio, debt ratio (short-term debt and long-term debt), solvency ratios, equity ratios and liquidity ratios you can use (search financial ratios), but if you have a tiny business such as myself you really don’t need the more complex analyses just yet.

Use these and compare how you are doing now to how you were doing and how you compare to others in your industry. These are essential to any small business owner and its shareholders who own either preferred stock or common stock to measure your business’s financial health.

Next Section: Lesson 7

Figuring your Break-Even Point

Previous Section: Financial Statements

How to Figure Your Break-Even Point

spencergregory — Sun, 23 Apr 2017 02:44:27 +0000

Lesson 7 in the Basic Accounting series:

Your small business’s break-even point is the point where the total revenue equals your total costs associated with the sale of your product or service or an even simpler accounting definition is the point where your business does not have any earnings and does not make a profit or suffer a loss.

Determining Your Break-Even Point:

As small business owners determining our break-even point can be a very handy tool in determining how much to charge for our product or service or where we might be able to even cut some costs. There are accounting break-even points and financial break-even points that share universal applicability whether it is a retail, manufacturing, or service business. Each one uses different measurements.

But before we start figuring at what point we can break even, let’s go back over some accounting terminology such as these important concepts:

Variable Costs of production: These are expenses that are associated with the production process or production level. They are directly proportioned to the production of your product such as raw material, factory labor, and sales commissions. For example, if you owned a bakery, your variable cost would be the price of raw materials such as flour, sugar, etc.
Fixed Costs: These are expenses that would be the same even if you did not sell any of your products such as rent, insurance, interest expense, etc.
Unit Selling Price: The total sales dollars or price you will be selling a single product or service for.
Contribution Margin: The amount generated after the variable expenses have been covered that will contribute toward the fixed expenses

Keeping those accounting definitions in mind, let’s discuss how to conduct a break-even analysis of your small business by using the break-even point formula:

Breakeven Analysis Formula

Breakeven Point = Fixed Costs/Unit Price – Variable Costs

Using these components of the break-even formula, you can determine how much of your product you will need to sell (total units sold) to break even. Once you have reached that point you have recouped all the costs that you have generated producing your product both fixed and variable. This is a calculation known as the margin of safety.

Figuring Your Contribution Margin:

Another important term used in break-even analysis is contribution margin (see definition above).

The following formula for figuring the unit contribution margin is:

Unit Contribution Margin = Unit Selling Price – Unit Variable Cost

Using the formulas above, let’s figure the breakeven point for a fictional bakery that sells cakes. The amounts and assumptions used in this example are also fictional.

We have figured that our variable cost for each cake we sell is $10. If we sell our cakes for $25 the contribution margin per cake would be:

Contribution Margin per cake = $25 minus $10

Contribution Margin per cake = $15

So the contribution margin per cake tells us that after the variable expenses are covered…$15 per cake will go towards paying the fixed expenses. Assuming we have $300 of fixed expenses per week, the point we break even in cakes per week would be:

Breakeven point in cakes per week = Fixed expenses per week divided by Contribution Margin per cake

Breakeven point in cakes per week = $300/$15 per cake

Breakeven point in cakes per week = 20 cakes per week

From this, we can see we would need to sell at least 20 cakes a week to break even. To double-check this we would use the following schedule:

Projected Net Income for a Week

Sales (20 cakes sold at $25 per cake) = $500 Minus variable expenses (20 cakes at $10 per cake) = $200 Minus fixed expenses =$300 Equals $0 Zero Net Income

Here is a good online break-even calculator to help you with your break-even analysis:

Break-even Point at dinkytown.net

From the general guidelines stemming from the concept of the break-point, you can figure out how to attain the desired profit or profitability goal. You can also analyze the company reach with another critical concept known as CVP analysis which will tell you how a difference in costs will affect the profit.