Learning the Language of Business: 7 Accounting Terms to Know
No matter your role in business, it’s important to have a strong grasp of accounting principles to help you better understand how your work impacts your company’s bottom line.
Whether you want to own your own business, aspire to join the C-suite at a Fortune 500 company, or are just looking to grow within or advance beyond your current role, here are seven important accounting terms you’re sure to encounter as you continue your business career:
1. Return on Investment
Return on investment, often abbreviated as ROI, is a percentage that shows the extent to which the earnings on an investment exceed or fall short of its costs. The formula to figure out ROI is net profit divided by the investment cost, multiplied by 100 to get the percentage.
For example, say a business would like to compare the ROI of two types of digital ads. The business spends $500 on each of two channels, Facebook Ads and Google AdWords. The company finds that the conversion value for Facebook ads was $1,000, while the conversion value for Google AdWords was $5,000. The ROI for Facebook Ads in this scenario is 100 percent, while that for Google AdWords is 900 percent. In this case, the business would want to allocate future digital advertising spend on Google AdWords campaigns.
ROI is also useful for business professionals who make product recommendations for company use. For example, an internet technology professional might want to recommend that a company invest in a piece of software that could double the efficiency of a task. The software may cost $100, but the work on the task that could be accomplished with the software delivers $1,000 in profit per year. The IT professional could make the case that the software would have an ROI of 900 percent.
2. Cost of Goods Sold
Product pricing strategy involves more than just accounting for raw material costs. Other factors that influence pricing include any cost associated with manufacturing or acquiring a product, like:
- Facilities rentals
- Product labor
- Vendor costs
Adding all these costs together gives businesses a more accurate picture of the value of the good or service that they wish to offer, which helps them develop more accurate pricing.
To calculate the cost of goods sold for a year, you would use the following formula: cost of inventory at the beginning of the year, plus the cost of additional inventory purchased throughout the year, minus the cost of inventory at the end of the year. For example, say you purchased $500 worth of hats to sell at the beginning of the year, and then you purchased an additional $1,000 worth throughout the year. At the end of the year, you still had $700 worth of hats on hand. Your year-end cost of goods sold would be $800.
Cost of goods sold is an important figure for businesses because it is a number required for business tax reporting, and businesses can deduct that figure from their gross receipts when calculating their annual taxes. Cost of goods sold also helps you assess your company’s profit, since subtracting cost of goods sold from sales is an important part of this calculation. Keeping track of this number can help a business understand which of its products or services are the most profitable, so it can constantly improve its business model.
3. Inventory Turnover
Inventory management is a vital component of business operations. If a company does not keep enough inventory on hand, customers will get frustrated when items are out of stock and take their business elsewhere. Conversely, having too much inventory will mean that warehouse space will get scarce and excess inventory may expire, become outdated, or become more susceptible to damage and theft.
That’s why keeping a finger on the pulse of your inventory turnover is important, especially in supply chain management. Inventory turnover is a ratio of how often inventory is sold out and replenished during a specific period. An accurate understanding of inventory turnover does more than just optimize business supply. It can also provide insights to businesses about which products are hot commodities and which ones might benefit from a new marketing strategy or reconceptualization.
Businesses use their inventory turnover figures to compare themselves to industry averages and gauge their performance. Generally, high inventory turnover is better than low inventory turnover, but not always. For example, if inventory turnover is high but a business has slashed prices on a certain item, the profit from that high-turnover item may actually be lower than a product with lower inventory turnover that is more strategically priced.
Increases in inventory turnover may sometimes be direct results of marketing or advertising campaigns, so low inventory turnover may cause a business to invest in advertising to see if a lack of customer awareness was the culprit. Watching inventory turnover and noticing spikes or trends can help a business understand which marketing campaigns are working and which are failing to connect.
Inventory turnover is calculated by dividing cost of goods sold by average inventory. For example, say a company has an average of $10,000 of inventory on hand and in one month, it sells $100,000 worth of inventory. This means that its inventory turnover was 10 times for one month.
Sales don’t mean much if the cost you’re putting into the product or service exceeds the price tag; this is where profit comes in. Profit is defined as the amount of total revenue a product or service generates minus the costs of expenses, taxes and labor required to produce it. Profit can only occur when revenue exceeds costs.
Let’s say a shoe company sells $200,000 worth of shoes in one month. That figure represents their revenue. In terms of costs, this company would need to subtract $50,000 for cost of goods sold (the materials and labor that goes into the shoes), $20,000 for operating costs (offices and employee salaries), and $10,000 for taxes and interest. The profit for the shoe company this month would thus be $120,000.
Some of the factors that can affect profit include:
- Changes in sales, which may decrease or spike as a result of marketing, economic conditions, seasonality and other factors
- Raw materials price changes, which can impact how much it costs to produce each product
- Operating expenses, which can be decreased by working with cheaper vendors or switching from human workers to robotic technology
- Labor costs, which can be affected by changes in minimum wages or by top business talent demanding raises
- Investments and business expenses, which may cause profits to take a short-term hit but increase profits over the long term (as in the case of investing in new technology or automation tools)
- Competition, including when a major competitor dissolves or when the market becomes oversaturated with competition
If a company’s profit is negatively impacted by one of the above factors, it may attempt to compensate by focusing on another. For example, if a company takes a profit hit because of new competition, it may invest in new technology that increases its production efficiency to position itself to deliver its goods or services at a lower cost relative to its competition.
You may have heard the term “equity” used in the startup world. Equity is often given in exchange for capital to fund a business, which can take the form of stock distributed to investing partners. The formula for equity is the value of an asset minus the amount of liabilities on that asset. An asset is something that can provide future cash flow or decrease costs, while a liability is a legal financial debt or obligation, like a loan.
For example, say a bakery owner has been in business for five years. The founder owns a physical space worth $200,000, owns $100,000 worth of equipment, owns $50,000 in supplies and generates $300,000 in profit per year. This means her assets are currently around $650,000. The founder owes $100,000 in loans, $30,000 to parts suppliers and $20,000 in salaries—totaling $150,000 in liabilities. This means the equity of her business is $500,000.
If the bakery founder decides to sell her business, this equity figure gives potential buyers a clearer picture of how much it is worth. When the equity value is negative, the business is less attractive to potential buyers and investors.
Some companies offer equity in a business through stocks to their employees. This type of equity can make employees feel more invested in the business, because they own part of it. This can increase loyalty and productivity, because the better the business performs, the more the employees’ stock is worth.
6. Burn Rate
Burn rate is a term that applies to startup companies or businesses that have raised capital to finance their operations. It is used to understand the efficiency of a company’s capital spending before they make a profit, and is usually expressed in monthly terms.
Here’s an example:
A cloud storage startup gets $10 million in funding from a venture capital firm. To fund office space and pay staff salaries, it spends $40,000 a month. This means that its burn rate is $40,000.
If the startup is earning some revenue—say, $10,000 a month from cloud storage subscriptions minus cost of goods sold—the net burn rate would be $30,000 ($40,000 minus $10,000), while the gross burn rate is $40,000. Having a lower net burn rate means that the company’s capital will last longer. If a business has an initial net burn rate goal that is exceeded as it operates, it may cut costs to slow down its burn rate. A business that wants to slow its burn rate may review staff efficiencies, evaluate subscription/recurring payment necessities, look into moving into less expensive office space or explore other tactics.
7. Accounts Receivable and Accounts Payable
Accounts receivable are assets that are owed to a company, such as payments for goods or services. Conversely, accounts payable are liabilities owed by a company, such as a payment for raw materials used to create a good.
Knowing precise values for accounts receivable and accounts payable gives a business an idea of whether or not they’re making a profit. Accounts receivable, which are in essence IOU statements, may be used when a business offers to collect payment only after a service is provided. An example of this on a small scale is when a cable company provides internet service to a customer and bills them for it afterward.
To track accounts payable, some companies will run a monthly tally of purchases by a client and then send one comprehensive bill. For example, instead of a company being billed for every single meeting it has with a law firm, it could owe one amount on a monthly statement of billable hours. This type of monthly billing can save a business time on invoicing.
There are many different types of invoicing methods for accounts payable. Others include:
- Interim invoices, which bill periodically throughout a project, so that a business consistently receives funds to continue work, whether it needs more raw materials or needs to pay employees
- Recurring invoices, which are sent at regular intervals based on ongoing work
- Ad hoc invoices, which can be sent at any point for a specific project, to ensure prompt payment and lessen the risk of nonpayment
Some businesses will demand payment for half the final price of the goods or services they provide upfront and then the rest of the payment once a project is completed. Businesses that want more cash flow upfront might charge earlier, rather than waiting to send monthly bills.
Sharpen Your Accounting Skills With an Online MBA
These are just a few accounting terms business professionals often hear, no matter their role. Entrepreneurs are especially aware of terms like these because they’re typically involved in the day-to-day finances of their business.
If you’re interested in growing your business knowledge and want to take the next step in your career, check out what else you could learn in the Online MBA program at William & Mary.