Bookkeepers do more than simply keep track of profits and losses. They record every financial transaction related to an entity. It is only with these records that business owners and accountants can analyze the overall well being of a company. Because there is so much varied activity related to a business on any given day, staying organized is paramount to a company’s success, and subsequently, one of a bookkeeper’s most important roles. How do they do it? With bookkeeping categories, that’s how.
All bookkeepers use the same five bookkeeping categories to keep transactions organized. Because all bookkeepers use these same designations, it creates a universal language wherein anyone who understands bookkeeping can judge the financial health of a company. Each category is important for understanding the financial picture of a company.
Profit & Loss Account
The five categories bookkeepers use are assets, liabilities, equity, income, and expenses. These five categories are then divided in two accounts. One of these accounts is called a profit/loss account (also known as a income statement). This account tracks the total amount of revenue coming in versus going out, or in other words, how much money you are making. (Things get a little more confusing with accrual accounting, but most small businesses use cash accounting.) It is made up of income and expenses. Income refers to any revenue coming into the business. This can include product sales, services, consulting income, etc. Expenses refer to the things you pay for in order to keep the business running. This includes payroll, rent, utilities, or any other overhead expense. The purpose of a profit/loss account is to determine your net income (profits). In order to achieve this, you simply subtract your overall expenses from your overall income.
|Income –||Expenses =||Net Income|
product sales, services, consulting income etc.
payroll, rent, utilities
Balance Sheet Account
Just because your income statement says you’re making lots of money doesn’t necessarily mean that your company is stable. This is why you also need the three remaining categories. They can tell you a lot about the financial health of your company. These remaining categories are assets, liabilities, and equity. They are grouped into what’s known as your balance sheet account. Your assets are everything you OWN or have the rights to. Some examples you would file into the assets category include bank accounts, cash, accounts receivable (what customers owe you), inventory, and equipment, just to name a few. Your liabilities are the things that you OWE. This would include accounts payable (unpaid bills), credit cards, loans, sales tax payable, etc. Finally, your equity is what the business is worth in a given moment in time. This would include your capital investment (your original investment), retained earnings (remaining profits), and shareholder contributions. When you add your total liabilities to your total equity, it should equal your total assets. This is why it’s called a “balance” sheet account.
|Liabilities +||Equity =||Assets|
|Examples: accounts payable, credit cards, loans, sales tax payable||Examples: capital investment, retained earnings, shareholder contributions||Examples: banks accounts, cash, accounts relievable, inventory, equipment|
Asset Liability Ratios
The best and easiest way to determine the financial health of your business is through your balance sheet account. A healthy business has a 2:1 ratio of current assets to current liabilities. Your current assets are assets that will be converted into cash within the next 12 months. Similarly, current liabilities are bills that are due within twelve months. For example, if your current assets total $20,000, and your current liabilities are $10,000, you have a healthy business. If you have a higher ratio, say 3:1 or even 10:1, it may be time to consider investing, or time to pay off loans with your excess capital. If you ratio is less than 2:1, you need to make changes in order to protect your company.
In summary, individuals and business need documentation of every single transaction in order to have a complete understanding of where they stand financially. However, this quickly amounts to an enormous amount of information. In order to save time, bookkeepers organize each transaction into specific categories. With this information in tow, business and individuals are able to make confident and informed decisions about the future of their enterprise.
There you have it. My OC Bookkeeper’s introduction to the most basic bookkeeping categories. Check out our introduction to balance sheets to learn a bit more about balance sheets, and check out our introduction to income statements to learn a bit more about income statements. Or, Investopedia is a great place to learn about all things business, finance, and accounting. And of course, remember to reach out to My OC Bookkeeper – Orange County’s best small business bookkeeping company for all of your bookkeeping and tax needs.
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