What in the world are Debits & Credits?

At this point in your business’ journey, you’ve probably realized that you need to learn bookkeeping for your small business.

But you probably don’t know anything about bookkeeping yet, and are wondering what is a Debit? And what is a Credit? And why do I need to know what these are?

I’m sure you’ve heard of “Debits and Credits” but always passed them off as terms reserved for accounting nerds.

And that’s totally fair.

Why would you need to know these terms if you aren’t an accountant, right?

Well, as a business owner, debits and credits are something you should become familiar with in order to properly keep track of your business’ finances.

Don’t stress though, we’ll help you easily understand these two crazy words.

 

The best way to explain what debits and credits are is to break it down in layman’s terms, slowly teach you how to use them, and provide you with the most important points to remember.

 

1. Equality is key

Every transaction you make to your books must have a debit and a credit that equal one another.  The total of the debits must equal the total of the credits. If you debit (increase) cash for $40 dollars, you must also credit (decrease) $40 to a different account. You cannot have one or the other, and you cannot have differing amounts. The equality of debits to credits, and credits to debits is the definition of “balanced books”.

 

2. Replace the difficult words with easy-to-understand words

Think of it this way, if I were to replace the word “debit” with “increase”, it would make sense if I said, “when I receive cash, I debit increase the balance in my cash account”, right? When first working with debits and credits, it’s easier for your brain to understand when you replace the word debit/credit with “increase” or “decrease”.

 

 

3. Know your 2 financial statements

Here’s where bookkeeping gets tricky — a debit isn’t always an increase. Sometimes it can be a decrease too. (I know, mind blown.) If I had to guess, your shoulders probably just shrugged and maybe a huge “UGH” came out from under your breath. You were originally thinking, “wow I finally understand! And now I’m just as confused as when I started.” We know how frustrating it can be. That’s where learning proper bookkeeping is important.

So how is a debit sometimes an increase, and sometimes a decrease to an account? The answer to this is whether you are talking about the balance sheet or the income statement. These are the two main financial statements/reports that will be very useful to you as a business owner. Both your balance sheet and your income statement have debits and credits on them, or increases and decreases.  The tricky part is they serve opposite purposes on each report.

 

1. Your first Financial Statement : The Balance Sheet

Your balance sheet contains your (1) assets (i.e. cash, accounts receivable such as money owed to you from vendors, fixed assets such as equipment, buildings, etc.), your (2) liabilities (i.e. accounts payable, such as money you owe to others, loans payable such as a loan balance you owe to a bank, and any other debts owed) and your (3) equity (monies put into the business out of your own pocket and your cumulative net income/loss each year).  Equity is really just the difference between your assets and liabilities.

ProfitUp Diagram 4

Think about doing something great for your business like increasing the cash that comes in, increasing your fixed assets like owning more equipment, reducing a loan you’ve been dying to pay off, or reducing the money you owe to vendors (accounts payable). When something is great or a benefit for your business, it’s a debit, (or better known as an increase).  So, on your balance sheet, debits = good!

What about the credits?  The credits on the balance sheet are the exact opposite.  When you think of cringeworthy business scenarios like reducing your cash, reducing your fixed assets like owning less equipment, increasing the amount you owe on loans (loans payable) or increasing the money you owe to vendors (accounts payable), those are all credits.  So, on your balance sheet, credits = bad!

What about the third portion of your balance sheet, equity?  As I previously mentioned, equity is the difference between assets and liabilities.  Let’s use some numbers to make this easier to understand. Let’s say you have more assets than liabilities. What’s the difference between the two?

  • Total Assets = $70,000 (debit)
  • Total Liabilities = $50,000 (credit)

Remember, debits must = credits.

To make the $70,000 debits equal the $50,000 credits, what do you need to add on? You need to add a $20,000 credit to equity to come up to the $70,000 assets.

 

2. Your second Financial Statement : The Income Statement

Your income statement contains just that, your (1) income (i.e. sales income, interest income, investment income, etc.) and your (2) expenses (i.e. payroll, insurance, rent, utilities, materials, etc.).  

ProfitUp Diagram 5.jpg

I’m going to be blunt, and I hate having to tell you this, but… the income statement is the exact opposite of what I told you about the balance sheet. (insert apology here)

If you want to do something good for your business such as increase revenue by selling more products, you credit the account.  So, on the income statement, credits = good!

By now I’m sure you see the pattern and can probably figure out the next step.  If you increase expenses such as overhead for your building or increased costs such as higher interest costs on your business loans, it’s not the greatest thing for your business. So, on the income statement, debits = bad!

 

I hope you thoroughly enjoyed this exciting journey into debits and credits (total sarcasm – we know it’s not the most exciting lesson).

But as you start recording these transactions on your own, remembering the simple tricks shared along the way, you will quickly get familiar with what is a debit and what is a credit, and how to use them properly.

I was as clueless as they come when I first heard the words debit and credit.

Now, after applying these simple tricks, I know debits and credits inside and out.

Debits and credits may not save lives, but it will make doing your books that much easier.

 

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