Understanding your business finances better often means getting to know the glossary of jargon that comes with them. Not all business owners are financial experts, nor are they required to be. But understanding terms like offsets can be invaluable in better understanding your financial position and accounting while helping to demystify the world of investments.
Here we’ll look at what we mean by an offset, and where the term is most commonly used to provide illustrative examples.
In its broadest sense, offsetting is a tool that can limit or eliminate liabilities in business and banking. Understanding offsets is like understanding Newton’s third law of motion. You know the one! “For every action, there is an equal and opposite reaction.” That’s exactly how offsetting works.
It nullifies financial entries with equal but opposite entries to cancel out the original entry. But what might this look like in real terms? Let’s bring this definition to life with some practical examples.
Offset in business
Businesses use offsetting all the time to balance their finances. Businesses may offset the losses they experience in one area of their operations by reallocating gains from elsewhere. Thus, the profitability of one business activity can be used to support other activities that, while not currently profitable, can help to facilitate growth and/or customer loyalty.
Loss leaders are a good example of this. A loss leader is a product that is sold at cost or at a loss in order to promote sales in other areas with higher profit margins. Let’s say a coffee shop gives away a free coffee with every slice of cake. Here the (negligible) loss from the coffee is offset by the profit made on the cake, combined with the potential influx of new diners lured in by the promotion.
Likewise, if you are thinking of expanding into a new market, territory or product range, offsetting will be crucial to maintaining cash flow. Growth of this sort inevitably comes with losses. But these losses can be offset by gains from products that are experiencing strong sales. Offsetting allows your performance to fuel your growth until it is self-sustaining.
Offset in accounting
The term “offset” is also commonly used in accounting. The principal is the same – an entry is offset by an equal and opposite entry elsewhere. Here, the original entry may be reclassified to either a deferred offset account or a revenue offset account. Offset accounts are also called “contra accounts”.
These accounts reduce the gross amount of other related accounts to achieve a net balance. For instance, a fixed asset account with a balance in debit may have a related offset account that carries a credit balance from accumulated annual charges for depreciation.
Offset in investments
Finally, offsets are also used in the options, futures and derivatives markets. They can reduce an investor’s net position in an investment to zero. To offset a futures position, a trader needs to enter an equal but opposite transaction. No further gains or losses are experienced from their position.
Investors will do this when they don’t want to physically receive any commodities associated with the futures contract.
In the options market, traders seek to offset risk exposures. These are often referred to as their “Greeks”. An options book exposed to declines in implied volatility (a long vega), may require a trader to sell related options to offset this exposure.
Options positions exposed to directional risk may require the trading of underlying security to become delta neutral. Delta–gamma hedging (or dynamic hedging) is also used by derivatives traders to maintain their offsetting positions in the long term.
We can help
If you’re interested in discovering more about offsets, accounting, or any aspect of your business finances, then get in touch with our financial experts. Find out how GoCardless can help you with ad hoc payments or recurring payments.