What can double-entry bookkeeping teach you about your business?
As a business owner, you might not have given double-entry bookkeeping much thought. While you don’t need to worry too much about the mechanics of it, the figures that the process generates can unlock a huge amount of invaluable business intelligence.
Failing to understand the output of double-entry bookkeeping could mean missing out on crucial insight that could help you make better decisions, address potential issues or capitalise on opportunities.
In this guide, we provide an overview of the double-entry bookkeeping process and what business owners need to know about the figures it generates. We’ll outline some of the most valuable insights this knowledge can unlock, and why having complete and up-to-date financial records is vital if you really want to understand how your business is doing.
What is double-entry bookkeeping?
Put simply, double-entry bookkeeping is a system for recording the impact of transactions in a business’s accounts. The methodology is underpinned by the principle that each transaction has an equal and opposite effect in a business’s records.
Every transaction posted goes into at least two accounting categories: once as a ‘debit’ entry and once as a ‘credit’ entry. Under double-entry bookkeeping, the value of a transaction’s debit entries is always equal to the value of its credit entries.
As long as all transactions are entered correctly, the figures will be correct in the business’s accounts. This means that double-entry bookkeeping includes a built-in mechanism for detecting errors. If the accounts don’t balance, the issue becomes apparent immediately.
The vast majority of today’s accounting automation tools are built on double-entry bookkeeping principles.
Why do business owners need to know about double-entry bookkeeping?
With accounting automation software like Xero, QuickBooks and Sage taking care of the mechanics, you might be wondering why you need to know anything about double-entry bookkeeping at all.
For business owners, the true value of double-entry bookkeeping isn’t in how it works; it’s in the insight it generates. At first, the output might seem like little more than a set of numbers. But when you know what the figures mean, you can gain a huge amount of invaluable business intelligence from them.
As the Federation of Small Businesses reports: “Whether you’re a sole trader or in charge of a small team, keeping in control of your finances is essential”. The good news is that with technology crunching the numbers in the background, you have more time to review the figures and reflect on what they mean for your business.
Which double-entry bookkeeping concepts are most helpful to understand?
Not a numbers person? Don’t panic. You don’t need to be a human calculator to learn how to assess the output of double-entry bookkeeping. You simply need a basic understanding of what some of the figures are and what they mean in business terms.
Here are some of the key terms and concepts from double-entry bookkeeping that will help you unlock the insight held in your business figures:
Debit and credit
The terms ‘debit’ and ‘credit’ are at the very heart of the double-entry bookkeeping methodology: Here’s what they mean:
• A debit is an entry that either increases a business’s asset or expense accounts or decreases its liability, income or equity accounts.
• A credit is an entry that either increases a business’s liability, income or equity accounts or decreases its asset or expense accounts.
Accounting categories
Under double-entry bookkeeping, a transaction results in at least one set of equal and opposite debit and credit entries being posted in at least two of a business’s account categories.
There are five main account categories in every set of business records:
- Asset accounts, which show the value of the business’s resources (e.g. cash, inventory and equipment)
- Liability accounts, which show how much the business owes (e.g. loans and accounts payable)
- Income accounts, which show how much revenue the business makes (i.e. its sales)
- Expense accounts, which show the business’s day-to-day running costs (e.g. rent and utilities)
- Equity accounts, which represent the claim that the business’s owners or shareholders have on its assets
A key trend to monitor is whether your business’s asset accounts are greater than its liability accounts. If your business has more assets than liabilities, it’s able to meet its financial obligations, such as paying off debts and fulfilling commitments to suppliers.
Cash and profit
Knowing the difference between cash and profit can have a big impact when it comes to understanding your figures:
• Cash refers to the funds that are available to the business and reflects the amount of money that the business has in its bank accounts. Cash transactions are recorded in the cash account on a business’s balance sheet, and are tracked in real time.
• Profit is a value that represents how much revenue is left once all the business’s expenses have been subtracted from it. The business’s profit is reported at the end of each accounting period and is recorded in a profit and loss report.
While cash is commonly confused with profit, there’s a clear and significant difference between the two. Cash is a tangible asset and refers to funds that are available to the business at any given time. Profit, on the other hand, is an accounting concept. It represents the difference between the business’s income and expenses over a defined time period.
Debtors and creditors
‘Debtors’ and ‘creditors’ are another pair of terms that are commonly confused with one another. Knowing the difference between the two is fundamental to understanding a business’s financial picture:
• Debtors owe money to your business. Customers who owe you money for work that you’ve performed are known as ‘trade debtors’. Other types of debtors might include individuals or organisations holding a deposit that your business has paid.
• Creditors are owed money by your business. Suppliers who are owed money by your business are known as ‘trade creditors’. Other types of creditors might include HMRC or employees who are owed wages.
Other financial KPIs
Once you understand these foundational concepts, you can start to look at your numbers in a bit more detail. Here are some important financial KPIs (key performance indicators) that every business owner should keep a close eye on:
- Debtor days is a metric that represents the average number of days it takes for a business to collect payment from its customers after making a sale. A low debtor days value can indicate strong cash flow and efficient credit management. Conversely, a high value could could indicate possible cash flow challenges or liquidity issues in the future
- Creditor days is a metric that represents the average number of days it takes a business to pay its suppliers or creditors after it receives goods or services from them. A low creditor days value indicates that the business manages its accounts payable process efficiently. A high creditor days value might have some advantages from a cashflow perspective, but it could put a strain on supplier relationships.
- Gross profit margin percentage is the remaining percentage of the business’s revenue once the costs associated with creating products or delivering services have been deducted. This figure can be a strong indicator of how efficiently a business is operating and whether it has the right pricing strategy in place.
- Net profit margin percentage is the percentage of the business’s revenue that remains once all its costs have been deducted. These costs include the business’s operating expenses along with interest, taxes and other non-operating costs. A business’s net profit margin percentage is an indicator of its overall profitability, along with how efficiently it manages its expenses in relation to its revenue.
In most leading accounting software platforms, these metrics are calculated automatically and are available to view at any time.
What business insight can these figures provide?
Double entry bookkeeping ensures that everything has been correctly registered in the records and then from which you can perform the calculations you need. Understanding these numbers will help you to see the full picture when it comes to your business finances.
This will help you to make better-informed and more strategic decisions, like how much money you can withdraw from the business or when you should invest in a new piece of equipment. You’ll also have a better understanding of the value of your business, which will be essential if you ever seek investment or consider selling.
Tracking metrics and KPIs that you understand will allow you to spot trends and patterns in your business. These might include warning signs and potential risks, which you can take steps to address. The figures might alert you to opportunities that you decide to capitalise on.
Keep your records up to date to get the best business insight
Your business bookkeeping figures can only provide you with genuinely useful insight if your records are complete and up to date.
If you have piles of receipts waiting to be processed, the numbers in your accounts will be out of date and won’t give you the clear picture you need to make the right decisions. Having incomplete records will also mean that any calculation or projection of your tax bill will be inaccurate. Staying on top of your bookkeeping activities, like recording expenses and invoices, is therefore vital.
That’s where Dext Prepare, our solution for auto-extracting financial data, comes in. It’s a brilliantly simple way for you to stay on top of your business bookkeeping and keep your accounts – and business insight – completely up to date.
Using state-of-the-art AI, Dext Prepare extracts data from receipts, invoices and bank statements and then sends it directly to leading accounting software like Xero, Sage and Quickbooks. All you have to do is take a photo.
With a quick and easy method for sending data to your double-entry accounting software, you’ll have complete records and numbers that provide you with the most up-to-date and valuable business insight.
Join us for an exclusive webinar with Dext’s Product and Accounting Expert Paul Lodder on 4th June, where we’ll show you how the right tech solutions can increase productivity and drive business forward. Register for free here: https://info.dext.com/bookkeeping-automation-with-dext