Diamond’s Business Services Team knows that entering the business world comes with questions. This guide goes over common business finance frequently asked questions.
What are accounts payable?
Accounts payable records all the business expenses you need to pay. These are either from buying on credit such as inventory and raw materials, or those expenses required to run your business, for example, rent, insurance, power, and internet. Essentially, any unpaid invoice you owe to a supplier would be classified as accounts payable. It sits as a current liability on your balance sheet as an amount owed.
What are accounts receivable?
Accounts receivable records all short-term amounts of money (less than 12 months) owed to you from customers who haven’t yet paid, also called debtors. This occurs when you sell goods or services to a customer on credit, meaning they don’t have to pay you immediately for your goods or services. It sits as a current asset on your balance sheet as an amount owed to you.
What is the difference between accrual and cash accounting?
The main difference between these two methods is the timing of when revenue and expenses are recognized in your accounts. Cash accounting is the easier method as it records revenue when cash is received into the bank, and expenses are recognized only when cash is paid out. Accrual accounting is different as it recognizes revenue when it is earned and expenses when they are incurred, regardless of whether the payment occurs now or in the future. For example, a customer is invoiced $20,000 in April with payment due on May 20th. In cash accounting, the $20,000 sale isn’t included in April as no cash has been received. In accrual accounting, the sale would be recorded for April as it’s been invoiced and the work done.
When can you write off bad debts?
Bad debts can be written off only when the customer invoice is deemed to be worthless or considered uncollectible, which means there is no reasonable expectation of payment in the future. To qualify as a bad debt, it must be a valid obligation of the customer to pay you and there is no chance of them paying.
What is a burn rate?
The rate at which a company is spending its cash reserves or capital to cover its monthly expenses such as salaries, rent, and other overhead costs. The burn rate is usually measured by monthly expenses less turnover, for example if you are spending $100,000 per month on expenses, and your turnover is $80,000, your ‘burn rate’ or the amount you’re losing is $20,000 per month. It is an important calculation for start-ups and businesses that are not yet profitable, as it helps estimate how long you can continue operating for before you run out of cash reserves.
How do you work out the cost of goods sold?
The cost of goods sold (COGS) represents the direct costs associated with producing and selling a product over your financial year. To calculate COGS, add beginning inventory (the cost of all the products, raw materials, work-in-progress, and finished goods you started the financial year with), add all your purchases during the year, then minus the ending inventory. It provides a value of the inventory that you must have sold over the year (accepting some may have been used up from wastage or theft).
What’s a creditor?
A creditor is anyone who you owe money to, such as a lender or supplier. Creditors can be individuals, but most often businesses you’ve bought something from. A creditor can also be a financial institution providing loans, credit cards, and lines of credit. The amount of money you owe creditors is usually included in accounts payable.
What is a debtor?
A person or business that has an obligation to pay you back in the future. For example, they have borrowed money or received goods or service on credit. Debtors are recorded in the balance sheet as accounts receivable, where you expect to receive payment from them later.
What is crowdfunding?
A financial method that allows businesses to raise money from many people, through donations of money from the public. This usually occurs via an online platform such as a crowdfunding website. Crowdfunding platforms typically work by allowing businesses to create a campaign or project page on the platform, where they can share information about the project, set a funding goal, and offer incentives or rewards to backers who contribute to the campaign.
What are current assets and current liabilities?
Current assets and current liabilities are short term obligations listed on your balance sheet, usually within 12 months of occurring. Current assets typically include cash, inventory, and accounts receivable. Current liabilities include accounts payable, short-term loans, and any accrued expenses such as insurance due. If you have more liabilities than assets, your business could be at risk, if you’re unable to pay upcoming costs.
What is depreciation?
The process of offsetting an asset over a period, spreading the cost of the asset over its useful life. It is used to reflect the gradual decrease in an asset’s value over time due to wear and tear, obsolescence, or other factors. For example, if an asset is purchased that should last 10 years before it needs replacing, the whole cost of the asset is not expensed. Instead, in this example, the cost is spread over the estimated 10 years of useful life, matching the expense of the asset with the revenue it generates over time.
What is the dilution of equity?
A term used to describe the situation when the original shareholders own a smaller share of the company. It is a term commonly used in the context of start-ups when a company sells shares, which results in the decrease of equity ownership for existing shareholders. For example, if you start a company owning 100% of the shares, then a person buys 25%, your equity has been diluted to 75%.
What are direct and indirect labor costs?
Direct labor costs are any costs relating directly to your product manufacture or service delivery. For example, a builder salary would be a direct labor cost of building a house. An indirect labor cost would be anyone where it is difficult to allocate their time to a particular product or job. For example, the HR manager of the building company where they don’t have a direct role in construction.
What are direct and indirect material costs?
All the costs of materials incurred in the actual production of your products or services for sale, traced back to the production of the finished good. These costs include the cost of raw materials and parts that go directly into producing a product. For example, a boat-builder’s material costs might include wood, fiberglass, engine and fittings. Indirect material costs are applied across the whole business, such as power or stationery across the whole business.
How is equity defined in a business?
Equity is the value of ownership interest left over in a business, calculated by deducting total liabilities from total assets. Equity is owned by shareholders and represents the value of the company’s assets that is left over for the shareholders after all its debts have been paid.
What is equity finance?
A method of raising capital for a company by selling ownership (‘equity’), to investors in exchange for money. This can be money invested by the business owners, friends, family, or investors like business angels and venture capitalists. Equity finance can provide a company with more flexibility and less risk than taking on debt, but it also involves giving up some degree of control and diluting existing shareholders’ ownership.
What is invoice financing?
When you borrow money based on the strength of the size of accounts receivable due, or you employ a factoring company who collects your accounts receivable on your behalf, taking a commission in return.
How do you value goodwill?
Goodwill is an intangible asset that represents the value of what is paid when a business is sold, over and above net assets. There are several methods used to value goodwill, the main one is based on the company’s expected future earnings. However, it is important to note that the valuation of goodwill can be subjective, and there is no one-size-fits-all method, depending on various factors, such as the future of industry, the company’s financials, and the purpose of the valuation.
What is an intangible asset?
An intangible asset is a non-physical asset with no fixed value that generates value to a company. Intangible assets can include items such as goodwill, intellectual property rights, patents, trademarks, copyrights, brand recognition, and customer lists. Intangible assets can be more difficult to value, as their worth is based on estimates of their future income-generating potential.
What does ‘just-in-time’ inventory mean?
The process of organizing your production so that raw materials arrive at the business ‘just in time’ when you need them. It prevents the need to have large piles of inventory, allowing you to free up the money that is normally tied up in stock (inventories) for more productive purposes. Businesses that make use of just-in-time inventories usually form a close bond with trustworthy suppliers who can be relied on to deliver quality goods or services at short notice.
What is a line of credit?
A flexible borrowing agreement allowing a borrower to withdraw money from an account up to an approved limit as and when they need it, such as working capital to pay bills, or making a large purchase. When using a line of credit, the borrower is only charged interest on the amount they have borrowed, not on the entire credit limit. Additionally, as the borrower repays the borrowed amount, the credit line is replenished, allowing the borrower to continue to access funds up to the predetermined limit.
