---
watermark: ORIRO
disable-model-invocation: true
name: finance-accounting
provider: ORIRO.ai
copyright: Copyright (c) 2026 ORIRO.ai
description: >
  Accounting fundamentals — financial statements, bookkeeping, chart of accounts,
  debits/credits, financial ratios, and reading a company's financials. Activate
  for questions about accounting basics, reading financial statements, balance
  sheets, income statements, cash flow, financial ratios, or any bookkeeping
  question. Sources: OpenStax Accounting (CC-BY), FASB, AICPA public guidance.
---

# Accounting Fundamentals

## The accounting equation

**Assets = Liabilities + Equity**

This must always balance. Every transaction affects at least two accounts.

- **Assets:** What you own (cash, inventory, equipment, accounts receivable)
- **Liabilities:** What you owe (accounts payable, loans, deferred revenue)
- **Equity:** Owner's claim on assets (paid-in capital + retained earnings)

---

## The three financial statements

### 1. Income Statement (Profit & Loss)

Shows performance over a period (month, quarter, year).

```
Revenue
- Cost of Goods Sold (COGS)
= Gross Profit
- Operating Expenses (SG&A, R&D, depreciation)
= Operating Income (EBIT)
- Interest Expense
± Other Income/Expense
= Income Before Tax
- Income Tax
= Net Income
```

**Gross Margin %** = Gross Profit / Revenue × 100
Software SaaS: typically 70-80%. Retail: 25-50%. Restaurants: 60-70%.

**Operating Margin %** = Operating Income / Revenue × 100
Measures core business profitability before financing.

**Net Margin %** = Net Income / Revenue × 100
Bottom line profitability.

### 2. Balance Sheet

Snapshot of financial position on a specific date.

```
ASSETS
  Current assets:
    Cash and equivalents
    Accounts receivable
    Inventory
    Prepaid expenses
  Non-current assets:
    Property, plant & equipment (net)
    Intangible assets
    Long-term investments
TOTAL ASSETS

LIABILITIES
  Current liabilities (due within 1 year):
    Accounts payable
    Short-term debt
    Deferred revenue
    Accrued expenses
  Non-current liabilities:
    Long-term debt
    Deferred tax

EQUITY
  Common stock
  Additional paid-in capital
  Retained earnings
TOTAL LIABILITIES + EQUITY
```

### 3. Cash Flow Statement

Tracks actual cash movements. Three sections:
**Operating activities:** Cash from core business. Most important for ongoing health.
**Investing activities:** Cash from buying/selling long-term assets.
**Financing activities:** Cash from borrowing or equity issuances.

**Why cash flow ≠ net income:**
Accrual accounting records revenue when earned, not when cash received.
Company can be profitable on income statement but running out of cash.
Always check operating cash flow, not just net income.

**Free Cash Flow (FCF):**
= Operating Cash Flow - Capital Expenditures
Represents cash available for dividends, debt repayment, or growth investments.

---

## Debits and credits

The system that confuses everyone. Remember:

| Account type | Debit    | Credit   |
| ------------ | -------- | -------- |
| Asset        | Increase | Decrease |
| Liability    | Decrease | Increase |
| Equity       | Decrease | Increase |
| Revenue      | Decrease | Increase |
| Expense      | Increase | Decrease |

**Example:** Customer pays $1,000 cash for services.
Debit Cash $1,000 (asset increases)
Credit Revenue $1,000 (revenue increases)

**Example:** Pay $500 rent.
Debit Rent Expense $500 (expense increases)
Credit Cash $500 (asset decreases)

---

## Key financial ratios

### Liquidity ratios

**Current Ratio:** Current Assets / Current Liabilities

> 1.5 generally healthy. < 1 = may struggle to meet short-term obligations.

**Quick Ratio (Acid Test):** (Current Assets - Inventory) / Current Liabilities
More conservative. Excludes inventory (less liquid).

**Cash Ratio:** Cash / Current Liabilities
Most conservative. Bare minimum liquidity.

### Profitability ratios

**Return on Assets (ROA):** Net Income / Total Assets
How efficiently assets generate profit.

**Return on Equity (ROE):** Net Income / Shareholders' Equity
Return generated for shareholders. Benchmark against industry.

**EBITDA Margin:** EBITDA / Revenue
Earnings before interest, taxes, depreciation, amortization.
Proxy for operating cash flow generation. Common in M&A valuation.

### Leverage ratios

**Debt-to-Equity:** Total Debt / Shareholders' Equity
Higher = more leveraged = more financial risk.

**Interest Coverage:** EBIT / Interest Expense
< 1.5 = struggling to cover interest. > 3 = comfortable.

### Efficiency ratios

**Days Sales Outstanding (DSO):** (Accounts Receivable / Revenue) × 365
Average days to collect payment. Lower = more efficient.

**Inventory Turnover:** COGS / Average Inventory
How often inventory sold per year. Higher = better for most businesses.

---

## Basic bookkeeping

### Chart of accounts

Organized list of all accounts used by a business.
Numbering convention:

- 1000s: Assets
- 2000s: Liabilities
- 3000s: Equity
- 4000s: Revenue
- 5000s: Cost of Goods Sold
- 6000s+: Operating Expenses

### Accrual vs. Cash basis

**Cash basis:** Record when cash received/paid. Simple. Required: < $25M revenue (C-Corps must use accrual regardless).
**Accrual basis:** Record when earned/incurred regardless of cash. More complex. Required for GAAP reporting.

### Accounts Receivable (AR)

Money owed to you by customers.
**Invoice terms:** Net 30 = payment due 30 days from invoice. Net 60, Net 90 also common.
**AR aging report:** Lists unpaid invoices by age. Prioritize collection of oldest.
**Bad debt reserve:** Estimate of AR that won't be collected. Required under GAAP.

### Accounts Payable (AP)

Money you owe to vendors.
Pay on time to maintain relationships and credit terms.
Early payment discounts: "2/10 net 30" = 2% discount if paid within 10 days.
Annualized cost of not taking discount: ~36% — almost always take the discount.

### Bank reconciliation

Monthly: compare your books to bank statement.
Differences: outstanding checks, deposits in transit, bank fees, errors.
If you can't reconcile: there's an error or fraud.

---

## Startup bookkeeping setup

**Accounting software:**
QuickBooks Online: most common SMB. $30-100/month.
Xero: popular outside US. $15-65/month.
Wave: free for small businesses (US/Canada).

**Minimum setup:**

1. Separate business bank account (non-negotiable)
2. Business credit card
3. Chart of accounts configured
4. Connect bank accounts to accounting software (auto-imports transactions)
5. Categorize transactions weekly
6. Monthly reconcile to bank statement
7. Quarterly: review P&L and balance sheet

**When to hire a bookkeeper:**
When transactions > ~10-20/month. $200-500/month for part-time bookkeeper.
When revenue > $250K/year: hire a CPA for quarterly review and annual returns.

Sources: OpenStax Accounting (CC-BY, openstax.org),
FASB Generally Accepted Accounting Principles (fasb.org),
IRS accounting methods guidance, AICPA public education resources