Having a solid control over your company's financials is an important part of running a business. This includes managing not only the company's cash on hand but also its debt. While there are several ways to do this, one of the more effective is to use a system of debit and credit accounting. Do you understand the meaning of debit and credit, though? More importantly, do you understand the differences between these two terms in reference to your business and how they are different than what you're used to as a consumer?
If you are a little fuzzy on the differences between credit and debit, you're not alone. That said, the more you understand about credits and debits, the better grasp you'll have on how your business spends its money. If you want to truly get a handle on your company's financials but find yourself unsure in this area, the best place to start learning is with the definition of debit and credit.
What Is Debit?
Debits are transactions that your business makes which cost money. This may sound simple, but it's a more complex topic than some realize. There are multiple types of debits in the business world, and getting them confused can mess up your books if you aren't careful. Fortunately, there is an easy way to remember the most common types of debits, so you don't run into this problem.
If you have trouble keeping track of what a debit is, think of the word DEAL. You can use this to remember that all debits are Draws, Expenses, Assets or Losses. In this case, "draws" are cash withdrawals or any other unaccounted-for cash that goes out of your business. "Expenses" are operating expenses, including costs such as utilities and payroll. "Assets" refers to money that's spent on the acquisition of physical assets, equipment or real estate. "Losses" are just what they sound like, investments that go south or other situations that cause the company to lose money.
Essentially, any money going out of your company is a debit. If you want to make sure, though, you can use this mnemonic to check. You can easily remember that the money drawn out of petty cash is a debit, as is the money spent on a new printer, new office space or the acquisition of other assets. Payroll, taxes and other business expenses also qualify as debits, as does the money lost when a big business investment falls through.
So if debits are the money going out of your business, what does that make credits?
What Is Credit?
As a consumer, you may think of credit as a secured or unsecured line of debt that you borrow against; these are most commonly seen in credit cards and other lines of credit. The credit definition in accounting is different, however. When you're talking about your company's financials, a credit is a good thing; it's the money that comes into your company, similar to how a debit is the money that goes out of your company.
As with the definition of debit, there is a helpful mnemonic to keep track of what constitutes a credit in the business world: GIRLS. The G stands for "gains," which represent increases in the company's share price. The I stands for "income," which is money that comes into your company not counted as a gain or revenue. This also means that R stands for "revenue," which is money earned through sales or services. The L is for "liabilities" which is income derived from a loan or other debt from an outside source. The S is for "shareholder equity," which is the money that shareholders have put into the company through investment.
Just as debits are all the money going out of your business, credits are all the money coming in. If you're not sure, apply your mnemonic and see if the money meets one of the categories of a credit. Income from new product sales? Check. A new loan to cover your business expansion? Check. Is there increased shareholder investment that leads to an increase in your overall share price? That's a check in two different categories.
So now that you've figured out what debits and credits are, what should your business use them for?
When Businesses Use Debit vs. Credit
The use of debit versus credit recording is part of the technique known as double-entry accounting. By splitting incoming funds from outgoing funds, it's easier to understand what's going on in your accounting ledger. Debits are recorded in a single column on the ledger sheet, while credits are listed in a separate column beside the debit column. This two-column structure lets you see at a glance when money is going out of your company and when it is coming in.
Within the double-entry system, each transaction is listed separately on its own line. If the transaction represents a debit, the amount of the transaction is written in the debit column for that line. If it represents a credit, the amount of the transaction is written in the credit column. No entry should have something written in both columns; if a transaction would somehow result in both a debit and a credit, the two aspects of the transaction should be written on separate lines so that the debit and the credit are recorded on their own.
The totals of the credits and the debits in your ledger are calculated separately. This not only helps you avoid mathematical errors that could occur when trying to combine individual credits and debits into a single total, but it also makes it easy to see how much money in total is going in and coming out.
Once you have the totals for your debits and credits calculated, calculate your company's total equity by subtracting the debit total from your credit total. If you have more debits than credits, you'll wind up with negative equity that requires additional funds to cover; this may mean the liquidation of some assets, taking on additional debt or drawing funds from savings or other company investments. If you have more credits than debits, however, then you have extra funds to use for expansions, funding the purchase of new assets or making new investments into your company's future.
What Does Credit Note Mean?
One thing that's important to learn about when dealing with the topic of business debits and credits is the credit note. You can think of this as something of a reverse invoice. The credit note is given to your business by a vendor or someone in a similar position when they issue you a credit. This may be a result of damaged merchandise that has to be returned to the supplier or an unsatisfactory service call, but these are only examples of times when a credit note could be issued.
The credit note itself is a receipt, identifying the reason that the credit is being issued and who authorized the credit. The credits associated with credit notes often come in the form of "store credit" or similar credit structures, giving your business a set amount of prepaid credit with the vendor or service provider on your next order or call. The credit note serves as documentation of this prepaid amount and is used by your accounting department to note the transaction as a credit in your ledger. Once you place an order, make a service call or otherwise use the credit, a debit is recorded in your ledger to signify the transaction that uses up the credit referenced in the note.
It is worth noting that debit notes also exist, and act in the opposite manner of credit notes. If a business issues you a debit note then it is in reference to a return or service problem that they had with your company. To honor the debit note you have to either process a return refund or issue prepaid credit for the amount of the note. Of course, in a situation where someone is unhappy with an item or service provided by your company it is more likely that you would provide a credit note instead of that individual drafting a debit note. As a result, credit notes are much more common and more likely to be used in the course of your business dealings.
Business Credit Considerations
The concept of credits, in relation to debits, is an important one for business accounting. Unfortunately, it sometimes leads to a bit of confusion for those who aren't familiar with double-entry accounting. Because of the different meanings associated with the word "credit," it's important to address the topic of credit lines and other forms of credit extended to businesses as well. Not only does this provide you with the information you need if asked to distinguish between the two, but liabilities are also still considered a credit in double-entry accounting.
Business credit cards and lines of credit are similar to what you're familiar with on the consumer side of things, but they are issued to the business itself instead of an individual. If your business is relatively new, you may need to provide personal information and submit to a credit check to secure business credit since most lenders aren't willing to issue credit to a business that has no real history. In this case, they use the owner's creditworthiness as a way to establish credit. This creates personal liability for you, but sometimes that can't be avoided. As your business becomes more established and does business with one or more banks, it will build its creditworthiness. At that point, you can apply for corporate credit cards, and other credit products issued based solely on the business reputation and its assets.
It is essential that these credit products are recorded as credits in your ledger, even though they represent debt in actuality. They are an expansion on your company's purchasing power and therefore are viewed by your accounting ledger as being the same as cash in the same amount. Purchases made with the credit products are still recorded as debits, of course, and the reduction in your available credit is recorded in the ledger by the fact that the debit reduced your total available equity (which included the amount of your credit line when you added that amount as a credit.)
Monthly payments on your credit lines will be added as expenses when the bills come in, reducing equity further as you make payments on them. Note that you don't add the payment back into equity after it is processed even though your available credit has expanded. Even though you have more credit available, you still have less cash on hand because you had to make the payment in the first place. This keeps your equity balanced as you repay your credit lines since each payment will require actual cash on hand. You won't add credit lines back in as a ledger credit unless your company opens a new line.