Tax Planning
Business owners wear many hats, but some are more important than others. Even with a financial expert’s guidance or a CPA on the team, having some tax knowledge as an owner is mandatory. Learning some of the essential terms to understand during tax season can make a big difference in how you run and protect your business.
If tax time makes you feel dread, you might want to start brushing up on the following 12 crucial terms.
Financial statements, also known as financial reports, are vital documents for every business. Although the type of documents in this category can vary, three statements rank higher than others in terms of importance.
The first report to commit to memory is the balance sheet. Think of it as a record of assets and liabilities that your company accrues over time. It outlines the owner’s equity by subtracting liabilities from assets.
Another essential financial report is the cash flow statement. This report looks at operating, financing, and investing activities inside a business. You can create cash flow statements for specific periods to determine how cash moves through a company by accounting for incoming and outgoing funds.
Finally, every business owner needs to understand the profit and loss statement. It directly shows a company’s profitability during a given quarter or year. That said, businesses can create profit and loss statements if they keep sound track of their numbers for any set period. Some might even look at monthly profit and loss statements when trying to figure things out.
Cash flow is a commonly used term in business, but many owners don’t fully understand it, confusing it for available cash, profit, capital, and even revenue.
Cash flow refers to how money moves through a business and is determined by the accounts receivables and accounts payables, or money coming in and going out.
Maintaining positive cash flow, or ensuring that a company has a higher influx of cash than an outflow, is a matter of balancing sales, expenses, capital, and other financial metrics.
You have to spend money to make money. That’s true whether you’re selling products or providing a service. Everything you do for clients incurs expenses of some kind.
Any cost directly linked to sales can be considered an expense. Of course, depending on the business, the timing of certain expenses can differ. This comes down to whether companies qualify to use accrual or cash accounting.
In general, businesses should keep expenses at a minimum. The lower a company’s costs, the more cash it can invest in growth.
But expenses can vary wildly, and some of them are unavoidable. Cost-cutting decisions should be made based on hard data to ensure it won’t compromise the delivery or quality of the products and services provided.
One of the ways companies increase their profitability is by finding ways to pay fewer taxes. Being able to deduct certain expenses is a great way to add money to the bottom line.
However, expenses differ between industries, state legislation, and other factors, and they’re not all tax-deductible.
Even a company’s tax structure or business model can influence what a business can deduct. This is an important term for understanding during tax season.
Making the wrong deductions can mean making additional payments, throwing off financial projections, and possibly incurring fines. Hiring a professional bookkeeping service or CPA is one of the safest ways to ensure that reasonable expenses are being deducted come tax season.
ROI is one of the most essential terms for understanding during tax season. Maximizing earnings is the name of the game for every for-profit business.
You can calculate this metric by taking the cost of a particular investment from the gain and dividing the resulting number by the cost.
It’s a simple profitability metric to determine, yet an essential one to know. Many investors and venture capitalists look at ROI before buying shares or investing in a company.
Business owners should also know their ROI to make better financial and business decisions regarding their operations.
Profit is often misunderstood, especially by newer and inexperienced business owners.
Making a sale adds to a company’s revenue. But before making a sale, a business might incur various expenses. A business can’t sell and increase its revenue without those costs.
So, while revenue numbers can be high, they’re far from an accurate indicator of profitability. A company’s actual profit comes from subtracting costs to determine the revenue from its sales numbers. What is left is the real profit made by the business.
When it comes to accounting, there are different sides to profits.
For example, the gross profit is obtained by subtracting the cost of goods sold from the revenue.
However, indirect costs that generate revenue are taken from the gross margin to determine the operating margin.
Another vital calculation has to do with net profit. Businesses do this by subtracting taxes and interest from the operating margin to get to the bottom line.
Most people think of assets as property and stocks. But in business, assets can be many of the things companies use to create value.
For example, products being sold to customers aren’t the only assets that contribute to generating revenue. Any materials used to create marketable products can also be considered assets.
An asset is generally measured by the economic value produced. Business owners then use opportunity cost assessments to determine if they’re investing in the most profitable assets.
Say two equal $100 investments would yield $5 and $10 in profit. The second asset offers an opportunity cost of $5 and is more profitable.
Borrowing money to buy assets or make any investment in the business is a liability.
The concept of liability is key to the idea of assets. If a company takes money from lenders to acquire assets, those lenders then have a claim on the company’s assets.
Therefore, the action isn’t considered an investment as it is a liability for the company.
Understanding liabilities and how to avoid them helps companies keep their credit rating high. It also clarifies some of the issues that may arise during tax season and a company’s ability to make payments.
Another of the most important terms to understand during tax seasons is equity. Subtracting the cost of liabilities from the value of the assets yields equity.
Alternatively, this is known as a share of ownership.
Many business owners confuse capital for equity.
Capital represents the available funding a company uses to buy assets, invest in equipment, or improve operations and includes debt and equity offerings used by companies to raise funds.
Complex financial analyses can determine various forms of capital, like working capital. A business’ working capital is the difference between short-term liabilities and assets.
Many business owners unfamiliar with tax law think tax credits and deductions are the same. However, these terms are far from interchangeable.
While tax deductions are subtracted from taxable income, credits are taken out of the tax bill.
A $2,000 tax deduction taken from a taxable income of $100,000 would result in a taxable income of $98,000. At an applicable income tax of 10%, the company would have to pay $9,800 in taxes.
Take the same taxable income of $100,000 and apply a 10% tax. The tax bill would equal $10,000. A company that can benefit from a $2,000 tax credit would end up with a tax bill of $8,000.
It’s essential to understand how tax credits and deductions work to avoid making the wrong calculations during tax season and potentially incurring fines during an audit.
This is also an essential distinction to make throughout the year as it can impact various purchases and investments.
One of the lesser-known but still important terms to understand during tax season is depreciation.
Many assets can depreciate over time. Therefore, businesses can use tax depreciation to list various assets as expenses and reduce their taxable income.
In this case, depreciation refers to a gradual deduction of declining asset values. Given enough time, an asset can be expensed down to zero.
However, not all assets can depreciate. A strict list of conditions must be met for an asset to be considered depreciated:
Knowing about depreciation and what assets you can gradually expense can be vital during tax season as it may directly affect the taxable income and net profit.
If you want to run a successful business, making sales or creating great products isn’t enough. The fact that it takes money to make money becomes increasingly more evident as the tax season grows near.
Every business owner should understand their financial situation, how money flows, and what the IRS, investors, creditors, and everyone else expects.
The more revenue you generate, the more you can deduct, and the lower the costs and liabilities you incur, the better.
If you need a helping hand or someplace to start, Swyft Books can be the bookkeeping service to guide you all year round. Take advantage of our free trial period and give us a test run.