Understanding Accounting: The Ultimate Guide to Finance for Business Owners

March 27, 2023
Financial Storytelling

I love business books. Honestly, I do.

Good to Great by Jim Collins, The E-Myth Revisited by Michael Gerber, and even The Effective Executive by Peter Drucker. The concepts and insights we can dive into and explore within entrepreneurial literature are vast. The things that we as entrepreneurs can learn about our businesses from reading others' experiences are unparalleled. Reading is the top reason I thoroughly enjoyed getting my Master's in Business Administration! There is so much to learn in the world; we only get a taste of it through books.

However, business books can only move our journey as entrepreneurs forward by so much.

Yes, you can use big ideas from authors like Jim Collins, Michael Gerber, and Peter Drucker to help build the business of your dreams. Though what happens when you hit a roadblock that you haven't read about? What do you do when there's a problem in your business that is unique to you -- to your industry, your staff, and you as the business owner? What story can you read that will help you improve your business, overcome your unique hurdles, and create the company of your dreams?

It's pretty evident when you think about it: you must read your own story.

Free course: financial storytelling basics.

Every business is unique. You have specific limitations, strengths, and processes for leveraging both. Your daily actions in your business create a story as unique as your company: when you make new sales by flexing your marketing muscles or promote your junior staff member to the senior level. You have written another line in your story even by providing a service to your customers.

By reading and understanding the tale of your business, you can see gaps and areas for improvement. You can hear how your business has grown and start planning for what's next. You can feel the way forward.

With all this ink getting spilled from every action you take, you'd think your business's story would be pretty straightforward to read, right? You're thinking: "please, give me the book; let's have it!"

Your story is available for you to read at all times. Before diving in, you must conquer three things: how to understand your financial story, where to find it, and what it means for the future.

Fair warning: once you've started on the journey of uncovering the story of your business, it's challenging to go back; you will no longer think the same about your business. You may find things that you don't like or want to change. Embrace the feeling of being uncomfortable. Once you push through, you'll find that your business can evolve into something greater than before.

So, let's begin.

Money is the Foundation of Your Story

On May 10th, 1965, Warren Buffett first acquired control over Berkshire Hathaway Inc., a struggling New England-based textile maker. Today, Buffett is best known for identifying troubled companies, purchasing them, and either gutting and selling them for parts or turning them around.

Berkshire Hathaway's value is currently over $645 billion as of 2022.

Buffett has had a meteoric rise in the business community over the past several decades. His wealth is shockingly massive, and his critics are dissentingly loud and vocal, but he continues to hold enormous influence over investors of all kinds. Regardless of what you may think about his business practices - whether you agree or disagree - Warren Buffett has an innate understanding of every company that Berkshire absorbs. He predicates his entire accumulation of wealth on this understanding from the beginning; he knows how to read their stories an d reads them well.

In March of 2015, the aging billionaire investor appeared on CNBC's Squawk Box - a morning news program that mainly discusses business and politics before the stock markets are open. During his appearance, Buffett made a seemingly small remark about accounting that has drawn much attention over the past few years:

Accounting is the language of business, and you have to be as comfortable with that as you are with your own native language to really evaluate businesses.

Accounting is the language of business.

The thing that all businesses have in common - every single company across the globe - is money. Cash flows into a business in the form of sales, it flows out of business for expenses or repayments of debt, and companies keep it in the form of Equity. Each of these activities is a short story detailing the way money moves.

All things in business eventually come back to money. Therefore, money is the foundation of every financial story written in the accounting language.

Money Problems? I Don't Have Money Problems.

The Coronavirus Pandemic caused many problems for small businesses. Precisely, many money problems.

Business owners immediately felt the effects of COVID-19 as restaurants shut down, office spaces were closed, and people stopped spending money. Relief came in the form of financial aid packages designed by economists and politicians to inject cash into an economy that had halted almost overnight. A few years later, small businesses still felt the effects of the pandemic even after reopening. Whether it was difficulty hiring, contractions in the sales revenue of every business, or just a change in the consumer mindset, many companies continued to feel the effects.

Money problems. It's all money problems.

When a small business is having trouble hiring and filling positions, it's because there's a disconnect between the incentive (compensation, benefits, and time) that the company is offering in exchange for work: a money problem. When sales aren't coming through the door because the marketing landscape has changed drastically: that's a money problem, too. When company culture gets shaken up because everyone is working from home and productivity drastically changes, money is affected.

The biggest problems that all businesses face often boil down to how effectively you use your money, how much you make, and how much you keep! That means that, despite any problem you might encounter, you can see it reflected in the cash your business is bringing in. By identifying the issues in your business, you can then implement solutions that will allow you to solve them.

Isn't that wonderful? Successful investors like Warren Buffett know that understanding your financial story and how money flows through a business can affect real change. This understanding allows you to build the company of your dreams. You can navigate uncertain situations and recover quickly from economic events. You can find confidence in your business.

Reading Your Financial Story

If you're with me so far, you've discovered that understanding your financial story can change the trajectory of your business for the better. You realize that everything happening inside your company has a monetary impact and that the only way to read and understand your unique story is by understanding the accounting language.

So, let's learn this foreign language together.

I'll be honest; I used to hate accounting. Throughout college, I struggled to connect the pieces in accounting classes because I couldn't grasp the language. Accountants typically teach in a way that only other accountants and robots can understand. So, say "sayonara" if your brain doesn't work like an accountant or robot (which are not always mutually exclusive). It wasn't until I approached accounting from a broken-down, real-life, human-first perspective that it clicked! Now the accounting language is beautiful and intuitive; it helps me grasp what's happening in my business on a level I couldn't imagine before. So, how does this language work?

Accounting Refers to More Than Just Being "Accountable"

Many business owners think of the action of accounting as simply helping them track their income and expenses to report to the IRS; accounting is the function of someone helping you stay accountable for tax time. The truth is, "accounting" is an entire system and language full of structure.

At a basic level, accounting is a "system of accounts," each containing money. The act of "accounting" is the action of tracking how money moves between these accounts.

Easy enough, right?

What are these "accounts," and why are they important? I'm glad you asked.  

An "account" is just a metaphorical bucket used by accountants to track how money moves. An account can be something as simple as Cash or Sales. More examples include Office Expenses, Software, or, my favorite: Meals and Entertainment. When money comes into a business, it generally gets marked as a Sale. Then, maybe you treated your team to a nice lunch, sending some money over to the Meals and Entertainment account.

Every accounting system comprises a list of accounts, colloquially known as the Chart of Accounts (COA). The Chart of Accounts is the lifeblood of your accounting system: it's a long list of every account, its type, and the amount of money within each, or the balance.

A sample of accounts that may appear on a COA.

Having a well-organized Chart of Accounts is crucial because if it becomes too crowded, it's incredibly easy to get confused regarding what money goes where. When creating your accounting system, you should only use clearly defined accounts in your COA that help you understand your business from a birdseye view. There's a balance between extremely specific and too broad, but more on that later.

So, accounts are like buckets; our Chart of Accounts is just a list of every bucket in the system. It turns out there are several different types of buckets, too. They all hold various things! The main types are:

  1. Assets
  2. Liabilities
  3. Equity
  4. Expenses
  5. Income

Assets: An asset is something your business owns that has monetary value with the expectation that it will provide a future benefit. The most accessible type of asset to remember is money. Cold hard cash intrinsically has value. So, your bank account is an asset. Land, equipment and investments are all assets as well because they are a store of value.

Liabilities: A liability is a monetary value you are obligated to pay someone else, sacrificing economic benefit to other businesses. The most common type of liability? Credit cards. Credit is a promise to pay for something in the future - effectively an IOU. That means loans and other money your business owes to someone else is a liability.

Equity: Equity calculates the monetary value you have left over after all liabilities have been satisfied. Equity will always be equal to your assets minus your liabilities! For this reason, things like your net income or money invested into the business are forms of Equity.

Expenses: Who doesn't love spending money? Expenses are just that: monetary value your business spends in the form of cash or credit. Expenses are the most commonly understood type of account, whether it's that fancy lunch you bought the sales team or the computer purchase you made for your new team member.

Income: The monetary value that you receive in exchange for the goods or services you sell. Sales are the most common form of an income account. Every business needs income; no one can survive without it!

Let's recap what we have so far: we build accounting systems using a series of accounts: buckets that hold value. The Chart of Accounts is a long list of all the account buckets within a given system. Finally, there are five different types of buckets. But how does this understanding help us read a company's story, let alone our own financial story? To understand someone's story, you've got to understand the context first! These concepts are the building blocks for a deeper understanding of the language of accounting.

Creating Our Manuscripts

Every story has a medium. Whether you're hearing urban legends passed down from generation to generation through vocal storytelling, reading a physical book, or swiping to the next page on your Kindle, we can consume stories using one of a few methods.

Financial stories are no different.

Financial stories aren't bound in a beautiful cloth book or recorded for an Audible audiobook. Enter financial statements: the manuscripts on which every financial story is written.

A financial statement is a formal record of the activities conducted by a business using data from its accounting system. Financial, of course, refers to the monetary value associated with each account. "Statement" refers to a document listing the value held in a selection of accounts, similar to a bank statement. A selection of accounts - that's the key phrase here. Whereas our Chart of Accounts may have listed out all the buckets within our accounting system, different financial statements group together different types of accounts to tell a story.

Your financial statements must remain clear and concise to tell the best financial story. Every account should contribute to illustrating your company's story; your accounts shouldn't be too general (enough detail to tell a story) or too specific (not too many accounts that the statement is unreadable).

The main financial statements we'll focus on are a Statement of Profit and Loss and our Balance Sheet.

The Anatomy of a Statement of Profit and Loss

The statement of Profit and Loss (sometimes referred to as an income statement or just "P&L") is one of the most versatile tools for understanding a business's financial story. The P&L groups together two categories of account types: Income and Expenses.

Every P&L shares the same basic structure - it begins with all income accounts listed at the top of the statement. Accountants refer to the top line as "Total Revenue."

Below our income accounts are all the business's expenses broken up into several categories, beginning with our "Cost of Goods Sold" accounts. Cost of Goods Sold (or COGS) is a bucket of expenses directly related to creating the income we see above. For example, if I'm selling candles through a Shopify store online, my COGS account would hold any expenses directly associated with manufacturing each candle. Without these expenses, I wouldn't have anything to sell. For that reason, things like Office Supplies or Rent would not be included in the Cost of Goods Sold.

Cost of Goods Sold

Subtracting our Cost of Goods Sold from our Total Revenue allows us to identify a Gross Profit. Gross Profit is an excellent measure to see the amount of money remaining after selling something. Businesses use this money to pay for the rest of their Operating Expenses.

Income and COGS

Operating Expenses are the next section of expense accounts on our P&L after we've calculated Gross Profit. You'll probably have guessed by its name that these expenses allow the business to operate normally daily. Operating Expenses include Office Supplies, Software and Subscriptions, Salaries, Advertising and Marketing, Rent, and Utilities.  

Expenses on a P&L.

Totaling up all our operating expenses allows business owners to identify the money needed to keep the business operational. By looking at the total cost of operating expenses every month, a story begins to become apparent. We can quickly identify a "break-even" number - the point at which the business's income equals its expenses. For new or struggling businesses, this is a helpful metric to identify as it gives an idea of what's needed for the company to remain operational.

We can identify our Net Operating Income (NOI) by subtracting our Total Expenses from Gross Profit. Our Statement of Profit and Loss is still incomplete, though. We have a few remaining ancillary accounts often categorized under Other Income and Expenses. These are typically small buckets of value, like Interest Income, Misc Income, or Other Expenses. They generally don't significantly affect the P&L, but they're necessary for a complete financial picture.

Finally, our picture is nearly complete when we subtract Other Income and Other Expenses to find our Net Other Income. Adding this number to our Net Operating Income gives us one of the most coveted and vital summaries on the statement of Profit and Loss: Net Income. After everything is said and done, Net Income shows the amount of money remaining, which is why it's often referred to as Profit. Our total sales revenue minus all of our expenses equals Net Income.

NOI and Net Income.

Profit is an integral part of understanding the financial story of any business. How much Profit is left after a period, whether a month or a year? Is this business running at a Profit or a Loss? This number allows you as the business owner to decide: will you take this Profit out of the company or reinvest it back into the business?

Recall our previous discussion regarding the Chart of Accounts; when we use too many account buckets in an accounting system, things get crowded and confusing. Our Statements of Profit and Loss show that clearly. Look at the different P&Ls below: on one side, we see a statement with numerous accounts and subaccounts becoming increasingly granular, whereas, on the other, we see concise and organized financial information.

Sample P&Ls

Which do you think would be more helpful in terms of making quick decisions about your business? When telling a company's financial story, it's easier to become bogged down by complex account structures and miss something important. The balance we're hoping to strike with any accounting system allows us to understand our financial story from a glance and make decisions without digging through the clutter.

For that reason, the simpler, the better.

The Anatomy of a Balance Sheet

Most business owners never take a look at their Balance Sheet.

They find it too confusing, don't understand the structure, and aren't sure why it's useful. You're not most business owners, though, are you? The Balance Sheet is a financial statement that groups together the remaining three types of accounts: Assets, Liabilities, and Equity.

The Balance Sheet is handy because it shows precisely how much cash is in the business and the value of your other assets against the money you owe. Let's get into it.

Sample Balance Sheet

At the top of every Balance Sheet, we have the company's Assets.

Quick reminder, an asset is something you own with monetary value that will provide a future benefit. Assets include all your business bank accounts, any physical cash you're holding onto, inventory if you're selling physical items, the money you plan to receive (aka receivables), investments, physical property, and equipment. Assets are a store of value.

Sample of assets on a balance sheet.

By combining a basic understanding of the net income numbers we saw on the P&L with the total value currently held by your business, you, as the business owner, will be better equipped to make growth plans. It becomes much easier to identify how your Assets will grow or shrink, allowing you to acquire new equipment, office space or even orchestrate the acquisition of another business.

Below the Assets listed on our Balance Sheet, we'll find the opposite category: Liabilities. Whereas Assets are things of monetary value that the business controls, Liabilities are a monetary value owed to someone else. Are you taking on debt to grow your business? Your loan balance will appear under  this section.

Sample of liabilities on the balance sheet.

The interaction of Assets and Liabilities can feel a bit confusing at first.

To help make the connection, consider how purchasing real estate works. If you and your family decide to buy a home, you head straight to the bank and consult a loan officer.

When closing on your home, the bank gives you the funds needed to make the purchase - hundreds of thousands of dollars - in exchange for your promise to pay it back in full plus interest.

On your Balance Sheet, you now have ownership of a new Asset: your home. However, you also have the responsibility of a new Liability: the mortgage that you have to make payments towards each month.

Let's say your home is worth $500,000, and the total loan you owe the bank is $400,000. On your Balance Sheet, you now have an Asset worth $500k and a Liability worth $400k. The difference in this equation, $100,000, is what we call Equity, the final section of our Balance Sheet.

As in our Real Estate example, Equity is the calculation of Assets minus Liabilities. It is the monetary value retained by the business after all Liabilities are satisfied. Equity is effectively the company's worth to its shareholders on paper; the company's "book value."

Equity on the balance sheet.

Our previous equation, Assets - Liabilities = Equity, is where the Balance Sheet gets its name!

\The point of the Balance Sheet is to identify the value within the company, which means that Equity will always equal Assets minus Liabilities.

It's a balanced equation.

When organized properly, this financial statement allows us to understand precisely the company's actual financial position in terms of its overall worth to the owners.

Therefore, a Balance Sheet is integral to making proper financial decisions.

Creating a Plan for the Future

As Francis Bacon once put it, "knowledge is power."

Since you've made it this far, take a moment and congratulate yourself. You should now have a basic understanding of how to read a financial statement. These are the pages of every financial story, and when put together correctly, they enable every business owner to achieve the highest level of financial clarity possible. Understanding your financial statements allows you to understand better how your company has performed in the past so that you can confidently step into the future.

Since you can effectively see into the past and understand the present, you can now create a plan for the future.

Using your P&L and Balance Sheet, you can create forecasts based on past performance by calculating an average of your financial history and projecting it forward. It's as simple as using the information you've seen in the past and identifying your goals for the future.

Regarding revenue, use your P&L to identify sales figures from the past quarter to create goals for the next three months. Identify your fixed monthly expenses and create a budget that allows you to understand the amount of money required for your business to operate - your break-even figure.

Take a look at your Assets to identify the amount of cash currently in your business and make decisions about the amount of Profit you can take out each month, quarter, or year.

My point is that you can use your financial history to write the story you want to tell. However, a warning: maintaining, understanding, and predicting the performance of your business requires excellent and timely recordkeeping.

While every business owner can deeply understand the story of their business, not every owner is meant to be a Storyteller. So, find an accountant, bookkeeper, or virtual CFO that you trust to help write your story. Work together as a team to develop goals and strategies for the direction that you see your business going in.

Once you've found the right partner to help you write your financial story, the entire world opens up.

Your business becomes far less stressful and a lot more successful.

You no longer feel alone in growing your business or confused about what to do next.

You'll find clarity and confidence.

Whatever your story has been so far, we're here to help you write the next chapter.

Schedule a call today.

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Jeremy Millar
Written by:
Jeremy Millar

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