What is your greatest strength as a business owner? Maybe you’re an excellent salesperson. Maybe you have a knack for predicting trends. Maybe you came up with a product so awesome that it practically sells itself.
The fact is, even the most talented entrepreneurs tend to struggle with one key business component: finances.
Managing your business’s finances can make or break your ambitions, especially in your first year of operation. Fortunately, with some basic finance term knowledge, you can turn your dreams into a success story.
Here are 15 finance terms that small business owners need to understand:
Depending on the scope of your new business venture, you’ll likely need to secure financing to set your goals in motion. A loan is a sum of money provided by a lender with the agreement that you’ll repay the full amount over time, plus interest. Business loan applications typically require items such as a business plan, financial statements, tax returns, and proof of collateral.
A business loan is usually given by a bank, but can also be provided by a private lender, family member, etc. Regardless of who lends the money, it is up to the borrower to repay a business loan.
Failure to repay a loan can have dire consequences.The borrower may be forced to turn over valuable business equipment and property, and it will be difficult to obtain a loan again in the future.
Bonus Tip: Don’t want to pay interest? Some businesses use other forms of financing such as existing equity (for example, a second job), “sweat equity” (doing all the work yourself until you have enough money to hire), friends and family contributions, and grants — more on those below.
Like a loan, a grant provides funds you need to operate and grow your business. The key difference between a grant and a loan is repayment. Whereas a loan requires repayment, a grant does not. Essentially, a grant is a gift.
Grants typically come from government programs, corporations, or special interest groups. Grants are often given to small businesses because these businesses help the local economy thrive. Unlike loans, the money is yours to use for your business needs.
Bonus tip: As you start, grow, and run your business, check for helpful grant information provided by the Small Business Administration (SBA).
Business assets are the items that your business owns. These items can be buildings, cash, furniture, vehicles, equipment, and more. Even elements like your trademarks or copyrights are considered assets.
There are some differences in how assets are calculated, and these differences depend on whether you’re tallying up assets for your balance sheet or for the IRS. Either way, it’s a great idea to gain a full understanding of what your business assets are moving forward.
A liability is something your business owes to another entity, such as money, goods, or services. Your liabilities include the items in accounts payable, wages your employees are owed, and any loans or mortgages associated with your operations.
Working capital is your business’s ability to pay your current liabilities with your current assets. It is represented by your current ratio — to calculate this, simply divide your current liabilities by your current assets. A ratio above 1 means you can cover your liabilities with your assets.
Once you’ve figured out your current ratio, do a bit of research to see how it stacks up against others in your situation or industry. This can give you valuable insights into how your company is being run or possible warning signs to look out for.
Understanding business costs is essential to basic budgeting. Fixed costs are expenses that occur regularly, on an ongoing basis, and usually have a flat (or “fixed”) rate. Fixed costs are predictable, so it’s relatively easy to plan for them each month.
Here are some examples of fixed costs for small businesses:
Whether it’s on a piece of paper, in a simple spreadsheet, or within a helpful tool or application, be sure to keep your fixed costs top-of-mind to avoid overextending your business financially.
Variable expenses can change month-to-month based on your activities. The change in variable costs is primarily a result of the amount of services you provide, items you sell, or products you create. Basically, the more business you do, the higher your variable costs will be.
The following are examples of variable costs for small businesses:
Here’s an example featuring variable costs for a pizza business:
|Flour, eggs, cheese, pepperoni
|Total variable costs
You can see that as production increases, so do variable costs. Keep that in mind as you make bigger operation plans or start to scale up the business to meet demand.
Again, other expenses, like lease payments for your location or equipment rental fees, stay the same. Those are fixed costs.
Your ability to cover short-term debts and financial obligations is measured by liquidity. In other words, liquidity describes how thoroughly you can cover your business’s liabilities using your business’s assets.
Another aspect of liquidity involves how easily you could turn your assets into cash. For example, money that you have in a business savings account is liquid. Other assets, like equipment or property, take time and effort to liquidate.
Liquidity is important because it can help you secure more financing for your business when you need to, and because it can guide decisions you make (such as purchasing new equipment vs. selling assets to keep more cash on hand).
To calculate your business’s liquidity ratio, divide your current assets by your current liabilities. A result in the range of 1.2–2 or higher is typically considered healthy liquidity.
There are many benefits to having healthy liquidity, but consider this: If you have the liquidity to make bigger purchases for your business rather than having to finance them and add to your overall debt, you’re saving your business some money and risk.
Sometimes, you’ll purchase items for your business on the spot. For example, you may head to an office supply store to grab items you need and pay for them on site. Other times, a vendor will provide you with products or services and send an invoice.
When an invoice is generated for your business, it falls under accounts payable. If you invoice a client, it will be a payable on their books. Any payments due on lines of credit (such as a business credit card) are also payables.
When your business provides a product or service to a customer who agrees to pay at a later date, the amount you are owed falls under accounts receivable.
Businesses with large transactions, subscription services like gyms or website maintenance, and construction and contractors are most likely to rely on receivables during day-to-day operations.
As you’re starting out, be sure you’re finding time to keep track of both accounts payable and accounts receivable. The dance between these two finance terms is what helps you balance your books and manage cash flow.
Gross revenue, also called gross sales, is the total amount your business earns from providing services or selling goods, prior to deductions. All the income received from your customers contributes to your gross revenue.
To calculate net income, subtract your business expenses from your gross revenue. Business expenses include cost of goods sold, advertising costs, maintenance, etc. You’ll need both your gross and net income calculations to track the success of your business and to complete your tax forms.
If your gross revenue is higher than your expenses, you’ll have a positive net income. If your gross revenue is lower than your expenses, you’ll have a negative net income. This is called a net loss. A net loss is not uncommon in the early stages of running a small business, but you’ll need to find ways to trim costs and increase revenue to become profitable.
This type of analysis helps you determine where your sales need to be in order to turn a profit. For new businesses, a break-even analysis will help you learn how much you need to sell in order to “break even” on your initial investment or to generate a profit given your variable and fixed expenses. Typically, a business with lower fixed costs will have a lower break-even point.
There are a couple different ways to conduct a break-even analysis, but getting to break-even (and of course, eventually, profitability) is a great goal to set for young businesses.
A profit and loss statement, or P&L, is considered the most important financial statement every business needs. It details the revenue and expenses of a business, and its profit or loss, over a period of time.
It’s a great idea to prepare a P&L quarterly (every three months), especially in the first year of operating your small business. You’ll need records of all the purchases you’ve made for your business, totals for all your sources of income, and information on any discounts given or returns made.
Helpful accounting services will allow you to generate a P&L, or you can do it yourself.
A balance sheet gives you a snapshot of the financial position of your business. It includes a breakdown of your assets and your liabilities. The more complex your operations become, the more complex your balance sheet will be.
Don’t be intimidated by creating your first balance sheet. It’s integral for spotting risks to your business, identifying needs ahead of time, and may even be required to apply for certain kinds of financing.
Incorporated businesses are required to provide balance sheets to the IRS and other authorities. Sole proprietorships are not required to prepare balance sheets, but again, it’s advised in order to monitor the health of your business.
Phew, that was a lot! But look above and skim these finance terms one more time — they don’t sound as intimidating anymore, do they? With these business basics under your belt, you’ll be prepared for the financial stuff while focusing on the fun stuff when it comes to running your business. If you need a hand along the way, don’t hesitate to reach out to the ZenBusiness team anytime.