7 Accounting Principles You Need to Know

The best way to tell how a business is doing is to look at the flow of money around that business. The financial records will tell you what the owner won't. Money in a business is like blood in the human body. You can tell what is dying by how it is flowing. If more money is moving out than coming in, then there is a problem.

Accounting, although not glamorous, is an important skill every entrepreneur needs to master. Entrepreneurs don’t need to have an in-depth knowledge of accounting. Instead, they need to understand the basics of interpreting financial records in order to spot things that are sometimes hard to see. Let me explain.

A business can be hot in the marketplace, have a huge amount of cash flowing in but be the edge of bankruptcy. A combination of things that could cause this is debt, interest rate, and cost of production. If the entrepreneur cannot understand the numbers, they cannot make the necessary changes ultimately putting their business at risk.

Accounting ledgers can be complicated. But there are 7 things an entrepreneur needs to watch out for to know the state of health of the business.

1. Debt repayment

When a business takes on debt, they have to constantly service it, based on the conditions the debt was taken. The amount of money a business has to pay monthly to service their debt is very important to any business. Businesses often go into debt for something that has a direct impact on revenue. If revenue is not positively impacted directly, then there is a problem on the horizon.

This first parameter is about the amount of the monthly repayment of the debt. It can be disguised and broken up into many forms in a financial record. But you need to find them all and sum them. You need this number. It is what keeps a business on its toes.

This is not about adding up the actual debts of a business. The actual debt doesn’t matter as long as the business can afford the monthly repayments. Also, you must not forget to factor in the interest on those debts. If you are not working as an accountant, a rough estimate might be good enough. This figure will be compared to other things.

2. Cash inflow

The next thing you want to know is how much money is coming in? And this is not about money coming from investors or loans. This is about money coming in from the sale of products or services of the business.

Forget about the deductions at this point and just focus on the gross income flowing into the business organically. This is about the actual payments the business is receiving. This is not about a payment that is coming in the future. It is about the payment received in real-time.

Some businesses try to hide this parameter not to face the fact of how much is actually coming in. Entrepreneurs like to be optimistic and often add some kind of future payments to this number. Meanwhile, the cash inflow is about money that has come in and not money that is promised. Even if products have gone out, the value of those products is not added to cash inflow until the money actually comes in.

3. Recurring Expenses

Recurring expenses are expenses a business has to keep making to keep it running. An example is staff salaries. Another example is the cost of raw materials (if the business makes products). There are several costs like this in every business.

There are also fixed expenses, but those are expenses that are made once and don’t have to be made again and again. That really doesn’t matter to the health of the business. But if there is a decision to have fixed expenses regularly, then it has become a recurring expense.

The value of debt repayments and recurring expenses must be much less than the cash inflow. If the gap is close or it exceeds the cash inflow, that is a sign of trouble. This is because taxes haven’t gone into the equation yet.

4. Taxes

This needs no special introduction. It is an offense not to pay taxes, so you have to do it. Unless you have become a big sophisticated business that can make deals with the government, you have to pay taxes the usual way. And there are all kinds of taxes based on the country you are.

You need to find out how much is going to taxes from a business regularly. This is also a form of recurring expense but it is different because it is a government-mandated payment. Taxes are arguably the greatest expense of businesses. And a lack of insight about taxes is going to end any company in problems.

The reason to look at the tax numbers separately is to know whether the business knows what they are doing concerning taxes. Are they paying too much taxes or they are evading taxes? The entrepreneur needs to know. There are tax incentives in the economic system of every country. If a business is qualified to take advantage of one and they are not taking advantage of it (to their own detriment) that says a lot about the competence level with which the business is run.

5. Margin per unit

This is how much you make on a unit of product or service. And it is simply calculated as the selling price minus the cost of production of that unit. In other words, margin per unit is how much value you are adding to one unit of what you offer to the marketplace.

Assuming you get the raw material (per unit) for 20 and the cost of production (per unit) is 20. And you sell for 50. This means your margin per unit is 10. And that is a very bad margin except the business is one that thrives on transaction volume. The reason is that taxes will take from that 10. Also, debt repayment will take from it. Meaning that you may not have much of a profit left after all due payments.

The example above is a 20% margin. That is 10 divided by 50 and turned into a percentage. A 20% margin is not good enough. For most seasoned investors, a good margin begins at 60%. And you should know that there are businesses that operate on margins as high as 90%. The higher the margins, the better the business (as long as people are still happy and able to pay for it).

6. Retention rate per customer

This is basically how often a customer buys again. Beginners think business is about products and services. But those who have been in the game for a while understand that business is about customers. It is about how many customers you have, how much they buy from you, and how often they buy from you.

Different businesses have different structures for their business. Some have corporate clients that buy from them. Some businesses sell directly to consumers. Some sell to institutions that then sell to consumers. But for every structure, there is an expected retention rate. If customers buy once and don’t have to buy again for a long time, it is a very bad business model. This is why tech companies that make gadgets that people are not supposed to replace in a few years are making things whereby consumers are buying from them multiple times within a year.

How long does it take the average customer to buy again? This would tell you how much the business is keeping its eyes on the customer. A business where the customers or clients come back to buy often is very good business. A business where this rarely happens requires serious improvements.

7. Customer timeline value

This is about how much the average customer is spending on the business over a specific timeline. If the timeline is a month (as an example), this is about how much the average customer spends on buying in that one month. More is always better.

Depending on what the business is offering to the marketplace, this value can vary from business to business. The things considered good for a business can be very bad for another. But this is one of the areas where the great decisions that improve a business arise from.

This is also referred to as ‘customer lifetime value’ in other contexts. But ‘timeline’ is used here instead of ‘lifetime’ to give a definite parameter to measure against. Measuring against time is a firm way to get the health state of the business.

Conclusion

As you can see, net profit is not included in the list. People prioritize it way too much. But it doesn’t really tell you what is going on in the business.

Savvy entrepreneurs are so good that they can spot impending problems in any financial statement at a glance. Getting the 7 basic accounting principles will help you do the same.

I hope you have learned something.