Key financial terms every business owner must know
As a business owner, you need to understand your customer, the market and how to sell your product or service, you also have to learn a whole new language of financial terms, even worse, try to understand your accountant or business banker. Here are some important financial terms you’ll come across while running your business.
THE FINANCIAL REPORTS
Financial statement: This is where you can see a big picture of your business. Your financial report lets you, the owner, know how you’re doing, and it can also show potential investors or the bank the state of your finances. The financial statement is a detailed outlay of all your financial activities.
Income statement: This document shows how your business performed over specific period of time. Also called a “profit and loss statement” or “P&L” this is revenue minus expenses to produce the net income figure.
Balance sheet: This is a summary of the financial big three: assets (cash on hand, owner’s equity and any money still due to your business), liabilities (what you owe) and owner’s equity (the amount invested in the company by shareholders or yourself). The balance sheet represents the financial health of your business at a given point in time.
Cash flow statement: A cash flow statement captures all the money that’s gone in and out during a specific period of time and details on where it’s going to and coming from.
FINANCIAL TERMS YOU WILL HEAR AND WHAT THEY MEAN
Assets: The things your business owns. Tangible assets include computers, furniture, office supplies and your inventory. Intangible assets are any trademarks or copyrights you own. Both types of assets are part of your business’s total value.
Accounts receivable: This is what you are owed. The work was done, you sent an invoice and now you’re awaiting the payment. On your balance sheet, you include “accounts receivable” in the assets column.
Bottom line: There’s a good reason this term is used in everyday talk to mean the final, end-all, total profit or loss. The last figure on your ledger, this is the number that shows what your business had made or lost at the end of each month.
Capital: A fancy word that covers all the types of money you’ve earned or were given to operate your business – assets, cash on hand and investments. There are two types of capital to keep straight: debt and equity. Debt capital is money you have to pay back, like a loan. Equity capital is a share of your business profit in exchange for funds up front.
Cash flow: Like a never ending tidal cycle, this is the money that comes in and the money that goes out. Cash flow is king and will give you a good idea of your long-term solvency and enable you to plan for the future.
Depreciation: Just like when you sell your used car for less than you paid for it, this term applies to the waning value over time of your business assets like computers, vehicles, etc.
Expenses: The cost of doing business, there is no such thing as a free lunch. Some examples are your overhead (rent, utilities), payroll and marketing costs.
Liabilities: The debt you’ve incurred since starting your business up to the present. There are two main types of liabilities: “current debt” such as what you owe your suppliers and “long-term debt” such as bank loans or accounts payable.
WHAT FINANCIAL REPORTS CAN TELL YOU
Profit and loss: Synonymous with “income statement” as defined above, your P&L is simply what your business made and what your business spent during a period of time. When profits regularly exceed losses, you know your business is healthy.
Break-even point: The equation that tells you how much money you need to make in order to recover the costs put into producing your product/service. First take the sales price (what your customers pay for your product/service) minus the variable cost per unit (what it costs to produce your product/service), then divide fixed costs (overhead, payroll, etc) by that number.
In practice if you are making cheeseboards from recycled wine barrels to sell at local markets and online,
Your fixed costs are $1000 per month to rent a factory space, rent a market stall, pay for marketing and website hosting.
You charge $10 for each cheeseboard which costs $5 to make.
So, $1000 divided by ($10 – $5) = $200.
If you sell 20 cheeseboards in a month you will break even, any other cheeseboards you sell are pure profit
Cash ratio: Exactly like balancing your cheque book, this equation tells you how much cash you have on hand to pay your current liabilities. Your total assets are divided by your total liabilities. For this ratio, the higher the number the healthier your company.
Cost of goods sold (COGS): This equation, most often figured at the end of your financial year, year-end, or any period of time that you track, tells you the cost of making/acquiring what you’ve sold. It’s determined by adding the value of your existing inventory at the beginning of the period/year to your purchased/manufactured inventory throughout the period/year minus the inventory left at the end of the period/year. This sum is considered a business expense. You will want to be as accurate as possible because the COGS goes on your business tax return and reduces your tax liability.
Debt-to-equity ratio: This is an equation that determines your ratio of liabilities to money invested. In short, it’s Total Debt / Total Equity.
Let’s say you have taken out a loan for $75K to start your cheeseboard business as well as invested $10K of your own savings. You have used this capital to buy machinery, equipment, pay for branding as well as your first few months of fixed costs.Over time you have managed to pay off $30K of this loan leaving you with $45K of debt.
Add that to your initial investment: $30K + $10K = $40K
So $45K (remaining debt) / $40K = 1.13
This means that your creditors are contributing $1.13 for every $1.00 you have contributed to your business.
This figure is valuable for comparison over time and to potential new investors.
Net income: This simple equation calculates all the sales you’ve made at the end of a period minus the cost of running your business (Profit – Expenses). In the startup phase of a new business this may be a negative number. If you track it until it’s a positive number you know you’re making profit!
Owner’s equity: Similar to the debt-to-equity ratio, this equation is figured by subtracting all your business liabilities from your total business assets. The answer is your equity or amount of ownership.
Your cheeseboard factory has grown over time and the business is now valued at $1 000 000, you owe $ 100K in loans and have given $300K in equity shares to investors.
You now have $600K in equity (now I am wishing I had invested in your business when you started)
Profit margin: This equation determines how much you’re actually making on what you sell. Take your net income (revenue minus expenses) and divide it by your total revenue to find the profit margin. A high profit margin indicates a financially fit company, while a low margin means it may be time to either lower your expenses or hike up your prices.
Valuation: Describes the act of estimating what your business is worth overall by adding up property, assets, inventory and anything else that contributes to the value of your business. Do this to show potential investors or potential buyers what your business is worth. Sometimes this is more of an art than a science but that’s for the accountants with white shirts and thick glasses (like me).