The words debit and credit have Latin roots, but simply mean left side and right side. Investopedia has a short explanation on the history of debits and credits.

Consider the debit and credit terminology as we use for our bank/investment accounts, debit cards and credit cards. When we make a deposit, i.e., credit, into our bank account we know that we have money in our account. However, from the banks perspective they have a liability. At some point the bank knows we will withdraw that money because it is rightfully ours. Using the same principles, when we make a purchase via a debit card or check we are taking money out of our account. The bank no longer “owes” us that money because they just “paid” it back to us through our use of the funds. The bank is using the correct accounting terminology from their perspective. However, it has really confused the everyday citizen about what debits and credits mean and how they are used in accounting.

Debits and credits are used to record business transactions. These transactions are recorded using a double-entry system which helps ensure the accuracy of the information and prevention of errors. While it is not a perfect system, it works most of the time.

It is not necessary to understand debits and credits in order to use your financial data. It is more important to understand the types of accounts used in your business and what transactions increase or decrease those accounts. Knowing why your profits are up or down is really where your energies should be focused.

Accounting data can be used to:
1. Determine how liquid your business is. By calculating a few ratios you can determine if you have enough current assets to pay your current debts. This is particularly important if you have one or more customers who are slow to pay you and you are anxiously awaiting their payments.

2. Assess your long-term solvency. Solvency is the ability to pay your long-term debts. If you are short on cash, will you be able to pay your long-term obligations? Even if you have good cash flow today, is there any possibility this may change? We need to think long-term so that our business can continue to operate effectively.

3. Provide a snap shot of how well, i.e., efficiently, your business is running. The income statement is a good place to see how well, or poorly, operations are generating revenues and managing expenses.

4. Obtain outside financing. A banker or investor will want to review your financial statements and perform their own analysis on the numbers. Your ability to obtain financing will be based on those results.

5. Make purchasing decisions, such as a new truck or equipment, or other business decisions such as moving to a bigger (or smaller) location.

The information reported on the balance sheet and income statement are truly a wealth of knowledge. Many people use the phrase “numbers don’t lie.” These numbers, if used and analyzed on a regular basis, will help you create a very effective and efficient business. In trying economic times, the regular use of your accounting data will prove beneficial for the long-term success of your business.

Each month you should compare your current Balance Sheet to the prior month and to the prior year the same month. How does the current Balance Sheet compare? Hopefully you have less debt this month than you did last month or last year. Did you add new assets? If so, how have those assets contributed to your revenue (you’ll have to analyze the Income Statement to answer this question)?

So what information does the Balance Sheet provide? Here are a few of my favorite Balance Sheet ratios with a description of the knowledge gained from the results:

1. Current Ratio. Determined by taking your current assets divided by current liabilities. You want a ratio of at least 1:1 or better. This ratio measures your ability to convert your current (short term) assets into cash to pay your current (short term) debt. Generally, a ratio of 1:1 isn’t going to give you enough cash to pay your debts so you want to strive for a 2:1 or better.

2. Receivables Turnover ratio. Compare your net credit sales to your accounts receivables by taking Net Credit Sales divided by Average Net Receivables. The result will give you the number of times per year you collect your accounts receivables. For example, if the result of the formula is 6 then you are collecting your receivables about once every 60 days.

3. Average Collection Period. Convert your Receivables Turnover ratio into days outstanding by taking 365 and dividing by the Receivables Turnover ratio result. Assume your Receivables Turnover was 12; we would then get 30.4 days your receivables are outstanding (ratio: 365/12).

4. Debt to Total Assets ratio. If you needed to convert your assets into cash to pay your long-term debts, would you have enough to cover your outstanding balances? The Debt to Assets ratio will tell you. To determine the proportion of debts to assets take your Total Liabilities divided by Total Assets.

Perform an analysis on your Balance Sheet for the current month. Then do the same for the prior month and the same month the prior year. What do the trends look like? What information have you gained from this analysis?

For a small business the Balance Sheet may not change much from month to month. However, checking the balances weekly or monthly for accounts receivable and accounts payable is a good practice. Determine how much of your accounts receivable balance is over 30 days old. What can you do to get your customers to pay within the next 10 days? Do you have any outstanding balances to your vendors that exceed 30 days? If so, will they be willing to continue to do business with you until the balance is paid?

The Balance Sheet can give you a snapshot of the overall business health. Do you own more in assets than you have in debt? If not, then you should consider what tactical, i.e., short term, actions you can take to reverse this trend. Are you liquid enough that you could pay your short-term debts, if necessary? What about your long-term solvency? Will you be able to service the long-term debt sitting on your books? Or should you contact your bank to negotiate a lower interest rate or extended payback period?

The information on the Balance Sheet is fairly logical and intuitive, which is probably why it gets overlooked as a financial tool for internal users. Consider how a banker might view the information on your Balance Sheet. Would you be willing to loan money to you? Do some analysis on the Balance Sheet to answer that question and then make a list of five things you can do to improve your company’s financial position.

First compare the prior month and same month the prior year by looking at the gross dollar amounts. You can gain some basic information about how your business is doing. While the dollar figures provide some information as to what areas to focus on in the future, it is helpful to convert some of this information into percentages to get a more accurate picture. For example, let’s assume that your Gross Revenues decreased slightly from May to June. It should follow that your Cost of Goods Sold decrease too. Assume that in May the Gross Margin was 60% but in June it was only 55%. What happened? Did your vendors increase their costs? Or did you sell your products at a discount in order to generate more sales? What is the trend in the Gross Margin over 6 months? Over 3 years?

There are many other ratios you can use to evaluate your business using the Income Statement. Since every business is different there is not one ratio that is necessarily more important than the others. Two of my favorites are:

1. Receivables Turnover (Net Credit Sales/Average Net Receivables) – provides the number of times per year that you are collecting your outstanding Accounts Receivables. You can convert this into days using the following formula: (365/Receivables Turnover ratio)=days.*

2. Profit Margin ratio (Net Income/Net Sales) – provides the rate of the conversion of sales into profits.

It is important to monitor the balance of cash in your checking account. However, a review and ratio analysis of the Income Statement will help determine how effective you and your business have been generating and using cash.

*Note, the Receivables Turnover ratio includes an item, average Net Receivables, from the Balance Sheet.

When reading an Income Statement start at the top, see a summarized Income Statement below. Gross Revenue is the first line item on the Income Statement. Gross Revenue is the accumulation of your sales. You can review your Income Statement monthly (required), weekly or even daily (depending on the accuracy of daily recording keeping).

If you own a business that sells products, i.e., you have inventory, you should have the line item Cost of Goods Sold. Cost of Goods Sold is the expense associated with the products you sold. You would have purchased these inventory items to sell in your wholesale/retail or online stores. Once these inventory items are sold you convert the asset into an expense, i.e., Cost of Goods Sold. If you have a service business you may report direct costs in the Cost of Sales account.

The Gross Profit is determine by subtracting the Cost of Goods Sold (or Cost of Sales) from the Gross Revenues. The Gross Profit is the amount of “money” you have left over to pay for operating expenses such as rent, utilities, staff salaries, insurance, phone, etc.

After you calculate the Gross Profit, you need to subtract the Operating Expenses. Operating expenses are the indirect cost incurred to run the business, such as rent, utilities, phone, and marketing expenses.

The last line on the Income statement will be the Net Profit. Hopefully this line item is a positive number. The Net Profit tells you how much “profit” you have per every dollar in Gross Sales. This is not necessarily your cash profit, especially if you had depreciation or made large purchases of equipment during the period.

Summarized Income Statement

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Gross profit is found by taking the net sales minus the cost of goods sold. For example, to find gross profit, a dressmaker make add up all of the receipts for the dresses sold, then subtract the cost of the fabric, thread, thimbles, the wages paid to a junior dressmaker who helped sew the dresses. The result is the amount of profit made only considering direct costs, i.e., gross profit. To convert the dollar amount into a percentage, take the gross profit divided by net sales, and multiplying by 100. While you can compare your result to other companies in your industry, it is generally difficult to accurately compare across companies using this calculation, so this is often done as an internal measure to see how the business is doing from year to year. Compare this ratio to the same month of the prior year or the previous month to spot any significant trends.

Net profit are the earnings remaining after you have accounted for all expenses, including depreciation and taxes. Net profit margin is found by taking the net profits (which is the profit after taxes have been paid) divided by revenue, multiplied by 100. Net profit can be used to compare your results to other companies within your industry. Since all items have been accounted in calculating the net profit margin, it allows for more comparability to the industry standard or your competitors.

Ratios provide a great means for measuring and monitoring business performance. These are just two of the many ratios that might be applicable to your business.

There are several advantages and disadvantages to debt financing and maintaining an appropriate debt-to-equity ratio is essential for securing future financing as well as for long term financial health. Financial experts cite numerous advantages to Debt Financing. One of the main advantages is that debt financing provides funding without diluting the ownership of the company. Additionally, with debt financing, lenders do not have a claim on any future profits of the company; the lender is limited to receiving an amount equal to the loan principal plus interest.  Most business owners find that raising capital from debt financing is much easier than equity financing as business owners do not have to comply with state and federal securities regulations. Debt financing also provides tax benefits in that the interest paid to service the debt is tax deductible.

Companies often find that there are disadvantages to debt financing. One of the obvious disadvantages is that funds financed through debt must eventually be paid back. In debt financing the principal and interest payments become fixed costs that must be accounted for when a company is determining its break-even point. Although debt payments occur on a fixed schedule, the payments require careful budgeting of cash flow which can be difficult for new businesses or business with highly varying business cycles. Debt financing also negatively affects the company’s debt-to-equity ratio causing lenders to view the company has a higher risk. With debt financing there is generally a requirement to offer company or personal assets as collateral to secure the loan. Small business owners often have to personally guarantee the loan, in full or in part. A personal guarantee means that if the company cannot pay back the debt the owner pledging the personal guarantee will repay the loan with his personal funds.

The decision to borrow funds from a bank or find an equity investor can be a tricky one. With debt you are only obligated to pay back the principle plus and interest component. With an equity investor you give up a portion of ownership in your company and your payment of dividends/distributions are variable over the life of their investment. An analysis to determine which option is best for your company should be completed before making a lending decision.

It makes sense to buy rather than lease an asset when:

1. You have the ability to use your cash reserves to pay for the asset. Or you have the ability to finance the asset through a bank or seller without hurting your debt covenants. You do not want to create too much debt for the business so take a look at the debt already outstanding before buying a new asset.

2. The asset will have a long estimated useful life and there is little risk of obsolescence.

3. You can take advantage of double-declining depreciation* in the early years of the assets useful life. This accelerates the benefit of tax deductions in the first few years of the asset life. *Double Declining Depreciation is a method commonly used for income tax purposes. Many businesses use Straight-Line for book purposes and Double-Declining for tax purposes.

4. You can afford the cash down payment or have the ability to obtain financing because the overall cash cost of the asset is less when you purchase vs. lease.

When you purchase an asset a few things happen from an accounting standpoint. The item is recorded on the Balance Sheet as an asset. The asset will be subject to depreciation so you’ll need to track the Depreciation Expense (which is reported on the Income Statement) as well as the Accumulated Depreciation (which is recorded on the Balance Sheet). In addition, as mentioned in point #1, you’ll have to record any related debt for the asset purchase as a liability.

The decision to lease vs. buy is not always an easy one. Compare the lists on the Lease blog post to this one and decide which option makes the most sense based on your current cash position.

When you lease an asset the transaction is fairly simple from an accounting standpoint. Since you don’t own the asset you are leasing there is no impact on the Balance Sheet, meaning you do not record the asset nor a corresponding liability for the debt (i.e., lease payments). You simply make monthly payments to the Lessor. Keep in mind, this is true for operating leases, not capital leases. With an operating lease you have no intent to own the asset at the end of the lease agreement along with a few other accounting tests to verify the lease is in fact an operating lease.

It makes sense to lease an asset when (i.e., operating lease):

1. Your cash flow is fairly low. Since you don’t have the ability (or willingness) to make a large payment to purchase the asset outright, a lease allows you to have access to the asset you need via monthly lease payments.

2. The asset is one where the risk of obsolescence is high, meaning that the technology will be outdated quickly. For example, many businesses lease rather than purchase computers/laptops for their employees because technology changes so quickly. Rather than being stuck with outdated technology they replace their computers every 2-3 years through lease agreements.

3. The debt on your balance sheet is a little too high or you have exceeded debt covenants by your lenders. If the asset you want to purchase is expensive, you might pay for it using some cash and financing the rest either through a bank or the seller. If you buy the asset, then you will need to record the corresponding debt on the balance sheet. If you lease the asset, you do not record any debt on the Balance Sheet.

Leasing an asset can be a good business decision, especially if you like the idea of no down payments and replacing the asset at the end of the lease term. Generally the overall cash cost of a leased asset is higher than that of a purchased one. There is no correct answer, it depends on what is the best option for your business.