Small business accounting 101

What is accounting?

Accounting for business is the process of tracking money coming in and going out of a business. It records sales, expenses, and other financial transactions to help businesses follow tax laws and prepare accurate financial reports.

Accounting provides data for tax calculations and reporting. It also helps businesses forecast and budget, and make informed decisions about costs, inventory, and investments to improve their cash flow and profits.

Accounting 101 for small business owners

If you get your accounting basics right, you’ll understand the performance of your business - and have all the information you need for building your business, doing your taxes, and meeting compliance rules.

Here’s some guidance on how to do accounting for small business.

Keep records of your business transactions

Bookkeeping – keeping financial records in business – aims to produce a reliable, up-to-date picture of your cash flow. You should then be able to see:

• Whether you’re profitable, or moving in that direction
• If there’s enough money to cover upcoming bills
• Everything you need (or your small business accountant needs) for your tax returns

Learn more in our guide on how to do bookkeeping.

Understand your financial statements

The three financial statements that best reflect your business’s financial health are the income statement, cash flow statement, and balance sheet.

• An income statement is an overview of your business’s revenue, expenses, profits, and losses over a set period, such as 3 months, or a year.
• A balance sheet shows what you own (assets) versus what you owe (liabilities). Unlike the income statement, it’s a snapshot of a single point in time.
• A cash flow statement shows your cash status by tracking money flowing in and out of your business. It helps you judge whether you can cover short-term expenses, like bills and payroll.

Track income and expenses

Tracking your expenses and income is vital for a healthy budget, so make sure you keep records of all your income (sales, services, and loans, for example) and expenses (such as your rent, supplies, and salaries).

Use the correct accounting method

There are two main accounting methods: cash and accrual accounting.

Cash accounting is often a simpler method that records money exchanges, excluding bills, and calculates taxes only on money received. It shows much cash you have available, and works well for small businesses.

Accrual accounting records income and expenses when they are incurred, and uses invoice dates for tax calculations. Although it’s more complex, the accrual method presents a clearer and more nuanced picture of a business’s finances.

So, think about your business’s size and the complexity of your transactions when choosing an accounting method.

Track accounts receivable and payable

Knowing your accounts receivable and payable gives you a fuller picture of your business’s financial health.

Accounts receivable tracks money owed by customers from the time you invoice them, representing the period between delivery and payment. This is recorded as an asset.

Accounts payable is money your business owes suppliers, marked as a liability from receiving a bill until payment is made.

Separate your business and personal finances

By separating your personal and business banking you’ll have a clearer record of your company’s transactions, making business balance-date calculations, like income tax, much easier. It also helps prevent business funds being used for personal expenses or personal money for business costs.

Xero makes it easy to separate personal from business expenses.

Manage your tax obligations

Tax is a significant part of small business accounting. The three most common types of tax that small businesses encounter are:

1. Income tax: You pay a portion of your profits to the government. The rate of income tax for businesses varies on the type of goods or services provided.

2. GST: GST is charged on most goods and services. Businesses must register for GST if their annual turnover exceeds a certain amount, depending on location.

3. Employee-related taxes: These include payroll taxes, where businesses withhold taxes from employee wages and submit them to the government.

Make sure you understand the specific tax rules that apply to your business in your region. This will help you avoid penalties and take advantage of any small business tax deductions on expenses like office supplies, energy, and other operational costs.

Accounting terms every small business owner should know

Here are some key fundamental accounting terms essential for managing your business effectively.

• Assets are everything your business owns, including your cash, equipment, and inventory. Knowing your assets is crucial for assessing your business's health and value.
• Liabilities are what your business owes, such as loans, unpaid invoices, provisional tax, and prepaid goods. Minimising liabilities helps maintain your company’s value.
• Equity is the difference between liabilities and your assets. If you were to settle your debts and then sell your business, equity is what you’d have left after the sale. Knowing the equity of your business can help you negotiate loans and attract investors.
• Revenue is the total amount of money generated by your normal operations over a set period. Knowing your revenue is important for calculating future budgets and potential earnings.
• Expenses are the costs of running your business. They include everything from supplies and staff costs to rent and taxes. It's important to track your business expenses to manage your cash flow and improve profits.
• Profit is what the company earns after deducting expenses from revenue. The different types of profit include gross, operating, and net profit. Use Xero's net profit margin calculator to determine what percentage of revenue becomes profit.

For a full list of accounting terms you should know, visit Xero’s accounting glossary.

Essential accounting checks to review weekly

Every small business should carry out weekly and monthly checks on the key areas of their business.

Sales

There’s no money without sales, so it’s important to track them closely for immediate feedback on your business’s performance. Monitoring sales trends helps you manage inventory and plan for future demand, too. Always consider the wider context, though, as higher sales may bring higher costs.

Profit

Gross profit reflects what’s left after you’ve reinvested in your products. Check this weekly for a good idea of your running costs, and calculate your gross profit margin to understand your leeway for expenses like rent and energy. And check your net profit margin to see how much of your sales revenue is profit. This is a good indicator of your business’s overall health and helps you compare your business with others.

Wages

Constantly monitor your staff wages to help you understand the true cost of your wages, including employee taxes and benefits. A sharp eye on your wage bill will also help you make smart staffing decisions, like optimising shift schedules or using part-time workers to boost profitability and productivity. . It’s a good idea to keep a weekly log in your wage book to minimise errors and to help with provisional tax calculations.

Money owed to you (accounts receivable)

Check that your invoices are paid on time to reduce cash flow problems for the business. Encourage timely payments by offering early payment discounts or applying late fees. Xero’s aged receivable report helps you track outstanding payments.

Essential accounting check to review monthly

Budgeted vs actual spending

Regularly compare your actual expenditure to your budget to identify where they differ. If you do this check monthly, you’re more likely to catch longer-term differences between your budgeted and actual spending. In particular, look out for price changes, unplanned activity, or accounting errors like incorrect tax codes. If your spending often goes over budget, check to see if you can find ways to reduce costs.

Liabilities

To stay on top of your liabilities keep your records up to date throughout your business cycle – using tools like a petty cash book or Xero.

One way to reduce liabilities and avoid missing repayment deadlines is to accelerate debt repayments to save on interest. To work out if your business can handle faster repayments, carry out debt ratio calculations (to measure your debt relative to assets), and financial reviews show if faster repayment is feasible. You could also negotiate better terms with creditors, if your business is financially stable.

Cost of goods sold

Cost of goods sold (COGS) is the direct cost to produce or purchase the goods you sell, or the materials you turn into goods. Fluctuating supply chain costs affect the prices of your goods and services so monitoring these changes helps you adjust prices and manage rising costs by (for example) finding cheaper suppliers or renegotiating terms. Make sure you check for inventory shrinkage, theft, damage, and product spoilage, as these all contribute to COGs.

Last year vs this year

Comparing last year’s figures with this year’s helps you gauge your business’s performance, understand the internal or external factors behind it, and know what you might need to change. Make sure you include important financial indicators like revenue, expenses, and profit in your comparisons.

How to stay on top of the numbers

Focusing on KPIs like cash flow, revenue, profitability, outstanding invoices, and equity helps you monitor your business’s financial health.

Xero accounting software helps you track these numbers. It automates everyday bookkeeping processes to streamline your financial management, helping you dodge financial surprises and supporting your business’s growth.

Of course, a small business accountant or bookkeeper is essential, too. A bookkeeper can make sure your books reflect your financial position, and an accountant will identify the most relevant financial metrics and give you strategic advice tailored to your business.

And Xero’s advanced analytical tools and customisable reports help you make better financial decisions.

Get help from an accountant or bookkeeper

A professional can make tax time so much simpler. They can also produce financial reports to show how the business is doing. Find one in the Xero advisor directory.