Common Accounting Terms used in Projections
In order to understand and be able to explain your financial projections, you need be become familiar with a few common accounting terms.
The 10 common accounting terms listed below are some of the most often used terms, and should help get you started.
Depreciation and Accumulated Depreciation
Depreciation is the reduction in value of a fixed asset due to wear and tear. Depreciation is an expense of the business and is charged to the income statement each period. Accumulated depreciation is the total of the depreciation charges to date and is shown in the balance below fixed assets.
On a unit basis, the gross margin is the difference between the selling price and the cost of product. If you sell at 100 and the cost was 80, then the gross margin is 20.
Gross margin can also be expressed for a business as the difference between total revenue and variable costs.
Gross margin % and Markup
Gross margin % and Markup are two ways of looking at the same thing depending on whether your starting point is selling price or cost for a product.
Gross margin % = Gross margin / Selling price
If the gross margin is 20 and the selling price 100, then the gross margin percentage is 20 / 100 = 20%
Markup = Gross margin / Cost
If your gross margin is 20 and the cost is 80, then the markup is 20 / 80 = 0.25
Long-term assets or fixed assets have a long life and are assets such as plant and equipment that lose value over time, and are subject to depreciation. Long-term assets are for use within the business and not held for resale. They are not part of the trading stock, and are not involved in the day to day working capital cycle of the business so are not readily convertible into cash.
Working capital is the amount of cash needed to fund the normal day to day trading operations of the business. In a simple business it would be calculated as inventory + accounts receivable – accounts payable which represents the funding needed to buy inventory and provide credit to customers, reduced by the amount of credit obtained from suppliers.
Equity is that part of your business finance which is provided by the owners.
Equity includes two main components capital which is invested as cash or cash equivalents by the owners as a capital introduction and retained earnings which are profits of the business which have not been distributed to the owners.
Accounts payable are amounts which are owed by you to your suppliers, they are sometimes referred to as trade creditors.
Accounts receivable are amounts which are owed to you by your customers, they are sometimes referred to as trade debtors.
Operating expenses or overhead costs are the indirect recurring costs of running a business such as administration, selling, research and development and premises expenses. They are all the support costs of a business which are not directly attributable to the goods or services that the business is producing.
Operating costs continue to be incurred whether goods or services are produced and sold or not, this is in contrast to variable costs which only occur when goods or services are produced and sold. Operating expenses excludes interest, depreciation, and taxes.
Cost of Sales
The cost of sales is the costs associated with producing the goods or services which have been sold during an accounting period. The items must have been sold otherwise there is no cost of sales.
The costs included in cost of sales are those necessary to bring the product to its present state and condition prior to sale. They do not include selling expenses, distribution costs, marketing etc such costs are termed costs of selling or selling costs or sales and marketing costs.
For a manufacturing, retailing or distribution business the cost of sales refers to the physical product and the costs of bringing it to the point of sale. This might include material costs, product costs, carriage inwards, direct labor costs and factory production overhead.
In a services business, the cost of sales is more likely to be wages, salaries and personnel costs for staff delivering the service, or perhaps subcontracting costs.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.