Essential Financial Terms You Need to Know
This is Part II of a three-part series:
– Part I: GAAP Basics (you are here)
– Part II: Understanding Margins
– Part III: Cash vs. Revenue
Before We Begin: What GAAP Is and Why It Matters
GAAP — Generally Accepted Accounting Principles — is the standard accounting framework used in the United States. It keeps financial information:
- consistent
- comparable
- honest
- and useful for real decision-making
When your books follow GAAP, your numbers have integrity.
When they don’t, you’re flying without instruments — and you won’t know it until something breaks.
This series sticks to strict GAAP definitions so there’s no confusion, no “street terms,” and no shortcuts that create future problems.
For Advisors: This series uses strict GAAP terminology to give your clients a shared financial vocabulary. Feel free to share these articles before planning meetings to align on foundational concepts.
Opening
Most small business owners are doing the best they can with the information they have. But when the financial language is unclear, everything becomes harder — pricing, hiring, forecasting, even basic stability. You don’t need an MBA to run a strong company, but you do need clean terms and a way to read your numbers without guessing.
This series is here to give you that foundation.
To keep things grounded, we’re using a simple example:
Craig Gilmore, owner of Craig’s Cleaners in Santa Ana, CA — a real, everyday operator trying to run an honest business with clarity.
1. Revenue
Under GAAP, Revenue is the amount earned when the service is actually provided.
It is not:
- cash collected
- customer deposits
- future work
- prepaid packages
Revenue is earned — not received.
Craig’s Example
$12 per garment
25,000 garments cleaned annually
Revenue = 25,000 × $12 = $300,000
Straightforward, but often misunderstood.
2. Cost of Goods Sold (COGS)
GAAP defines COGS as the direct costs required to provide a service.
For Craig, this includes:
- cleaning solvents and materials
- direct labor (team members doing the cleaning and pressing)
If a cost doesn’t touch the garment directly, it doesn’t belong in COGS.
Craig’s Example
Materials per garment: $2.00
Direct labor per garment: $5.00
Total COGS per garment = $7.00
Annual COGS = 25,000 × $7 = $175,000
3. Gross Profit
Gross Profit = Revenue – COGS
This is the first real signal of the business model’s strength.
Craig’s Example
Revenue: $300,000
COGS: $175,000
Gross Profit = $125,000
This is what Craig has available to pay the overhead required to keep the doors open.
4. Operating Expenses
Operating Expenses are necessary to run the business but aren’t tied to a single garment.
For Craig, this includes:
- rent
- utilities
- admin labor
- insurance
- software
- marketing
- maintenance
A lot of small business owners blend these with direct labor, which makes it impossible to see true performance.
5. Operating Income
GAAP definition:
Operating Income = Gross Profit – Operating Expenses
This shows the health of the company’s core operations.
Craig’s Example
Gross Profit: $125,000
Operating Expenses: $100,000
(includes Craig’s $60,000 salary + $40,000 overhead)
Operating Income = $25,000
If this number is weak, the business needs structural adjustment — not “more customers.”
6. Net Income
GAAP formula:
Net Income = Operating Income – (Interest + Taxes + Depreciation + Amortization)
This is the true bottom line.
Craig’s Example
Operating Income: $25,000
Interest: $2,000
Depreciation: $5,000
Taxes: $3,000
Net Income = $15,000
Important note:
This is after Craig takes his own salary.
Many small business owners misunderstand this.
The $15,000 isn’t “Craig’s income for the year” — it’s what the business produced after paying Craig, his staff, his expenses, and all required GAAP adjustments.
It’s the number that tells the truth about performance.
Common Owner Mistakes
Even smart, hardworking small business owners run into problems when fundamentals aren’t clear:
- treating deposits as revenue
- putting indirect labor into COGS
- confusing cash in the bank with profit
- ignoring depreciation
- misreading margin changes
- mixing personal and business expenses
- assuming gross profit equals “available cash”
These mistakes aren’t moral failures — they’re the predictable result of unclear vocabulary.
Why This Matters
Clear financial language brings stability.
When small business owners know what they’re looking at, they make calmer decisions, price more intelligently, and recognize issues before they become crises.
Financial literacy isn’t academic.
It’s operational survival.
What to Do This Week
Pick one:
1. Pull your last P&L and verify your COGS contains only direct costs (materials + direct labor). If overhead or admin salaries are mixed in, ask your bookkeeper to separate them.
2. Check your balance sheet for “Customer Deposits” or “Unearned Revenue.” If you see customer deposits sitting in Revenue instead, flag this for correction.
3. Calculate your actual gross profit for last month: Revenue minus true COGS. Write the number down. This is your margin before overhead — and it’s the first number that matters.
If you find misclassifications, don’t panic. Just get them corrected going forward. Clean numbers lead to clear decisions.
Conclusion
A business becomes stronger the moment its owner understands the language of its numbers. These GAAP terms aren’t theory — they’re tools. The more fluent you become, the more confident your decisions feel.
Part II will break down margins — what they reveal, why they matter, and how Craig Gilmore uses them to understand performance long before his bank balance changes.