Opinions expressed by Entrepreneur contributors are their own.
When you jump into the world of entrepreneurship, it’s easy to get overwhelmed. From learning about marketing and sales to books and payroll, it’s a giant learning curve. Everyone comes in from different backgrounds and experiences they bring into their journey. For those without any financial background, it can be overwhelming to do the administrative aspect without proper resources.
While it’s always smart to hire a bookkeeper or an accountant to help with the financial aspect of your business, understanding the nuances of finances and taxes is also highly beneficial to ensuring things are done right. Here are three terms all entrepreneurs should know to ensure that their books and finances are in order.
1. What is your cost basis?
Your cost basis is an important part of starting your business. Simply put, it’s the amount of capital you’ve deployed to start your business. That number matters down the line as you start to increase your revenue and create profit.
When starting your business, it often takes a decent amount of capital to purchase equipment, lease office space, pay employees and more. These expenses can seem daunting and even more overwhelming if you had to pay taxes on net revenue generated in the first year or the first couple of years of business.
The great part about understanding cost basis is that keeping track of this number helps you during tax time to understand what you owe. Since you’ve already earned the money, and paid it isn’t taxed again. So if you spend $100,000 on getting your business up and running, and you net $300,000, you can repay yourself $100,000 without paying taxes on it.
Your cost basis is an important number to keep track of to understand the financial health of your business and to ensure you’re not paying more in taxes than is necessary. Make sure you keep track of it and those transactions.
2. What is commingling?
Commingling is something we often see when an entrepreneur is moving quickly in building their business and often with side hustles as well. Commingling happens when you are using the same bank account or credit card for both personal and business. Not only can it make things difficult to track expense-wise, but it can also be a flag for an audit.
In a traditional sense, commingling is the act of combining funds. In investing, it can be beneficial, but in a business, it can lead to all sorts of problems. One of those problems is when you apply for a business loan, it can be hard to clearly define business income vs. other funds and understand your cash flow. Keeping these funds separate will be much easier for you or your bookkeeper to establish what your cash flow is and help you understand what size loan you might be able to qualify for.
At the end of the day, it’s extremely important for a business owner to understand what commingling is and to avoid it at all costs. Do so by starting a separate business bank account and using a separate credit card for business transactions, even if it’s a personal card that you only use for business purposes, while you build enough revenue to apply for a business card.
3. What is depreciation?
Depreciation, or a depreciation expense in business, is the ability to write off a physical asset or fixed expense, such as a car, as it depreciates over time, less the salvage value. Essentially you can write off a fixed asset as an expense if it’s used for business purposes. It’s considered an operating expense. Understanding this will also help you at tax time, so you’re not paying more than what’s truly owed.
For instance, if you purchase a computer for $3,000 and plan to use it for four years and resell it for $400 at the end of those four years, your yearly depreciation expense would be $650.
There are multiple ways to calculate depreciation expenses, the one described above is called the straight-line method. Other methods accelerate the depreciation of the asset and allow you to write off more of the expenses earlier on in your life. Talk to a tax advisor to better understand these accelerated methods and why you would use them.
Understanding these three terms as a beginning entrepreneur will help you set yourself up for success and avoid headaches in the future. Most importantly, consult the proper experts for your accounting, bookkeeping and tax planning needs.