Hi, 10 Finance Terms you should know. Whether you’re getting the hang of balancing your books, analyzing financial statements, or applying for a business loan, there are a bunch of business finance terms that entrepreneurs need to get familiar with.
10 Finance Terms
We’re going to cover the 10most important business finance terms. As a small business owner, it’s important to know where your company stands financially at all times.
To understand what’s going on with your company, you’ll be balancing your books, typically on a monthly basis, either yourself or with the help of a bookkeeper or accountant. You’ll need to make an important decision at the outset: Do you want to follow accrual basis accounting or cash basis accounting?
The decision impacts when revenue and expenses are recorded on your books, so it can also impact income and profitability estimates for your business. Accrual basis accounting recognizes revenue when it’s earned and expenses when they’re billed.
Let’s take a simple example. Let’s say you have a landscaping business called Awesome Landscaping Corp., and you book a job to design Casey Customer’s garden on July 1. Casey pays you on July 15 using her credit card. When will this revenue be recorded?
Under accrual basis accounting, the revenue will be recorded on July 1 because that’s when you booked the job and made the sale. In order to prepare for the job, let’s say you also place an order for landscaping supplies with your vendor on July 3.
The vendor hands you an invoice that someday, July 3, but you only pay it using a check on July 10. When will this expense be recorded under accrual basis accounting? The expense will be recorded on July 3 because that is when the vendor billed you. The other accounting method, cash basis accounting, is our second business finance term.
Under cash basis accounting, revenue is recognized when it’s received, and expenses are recognized when they’re paid. Most small business owners use cash basis accounting because it’s simpler than accrual basis accounting.
Let’s use the same landscaping example to see how cash basis accounting works. Let’s say you own Awesome Landscaping Corporation, and you book a job with Casey Customer on July 1. Casey pays you with a check on July 15, and you deposit the check that same day. When will this revenue be recorded?
Under cash basis accounting, the revenue will be recorded on July 15 because that is when you actually received and deposited the check from Casey. You also place an order for landscaping supplies with your vendor on July 3.
The vendor hands you an invoice that someday, July 3, but you only pay it on July 10. When will this expense be recorded? Under cash basis accounting, the expense will be recorded on July 10 because that’s when you actually paid the invoice.
Next, we’re going to cover some business finance terms that you’re likely to come across when analyzing financial statements, either on your own or with the help of your accounting or tax professional. For example, you’ll spend a lot of time as a business owner analyzing profitability.
But what exactly does the term profit mean? Profit measures how your business’s revenue compares to your company’s costs. There are several different measures of profit, including gross profit, net profit, and net profit margin. Gross profit is your business’s total revenue minus the cost of goods sold.
The cost of goods sold is simply the expenses associated with producing and selling your goods. More commonly, you might hear the term net profit. Net profit is basically your bottom line. It takes gross profit one step further by subtracting all expenses from your revenue, including cost of goods sold, operating expenses, taxes, and interest.
If your net profit is a positive number, then your business is in the black, and you are operating at a gain. If your net profit is a negative number, your business is in the red or operating at a loss.
Finally, net profit margin takes your net profit and divides it by total revenue. Net profit margin differs from industry to industry and as a good indicator of how your company is performing relative to competitors.
Let’s take an example using Awesome Landscaping Corporation. Let’s say the business generated $100,000in revenue last year. It cost $50,000 last year to offer their landscaping services, and other expenses for the year totaled $25,000. Is awesome landscaping profitable? Yes, it is, and here’s why.
To calculate gross profit for Awesome Landscaping Corporation, we will simply take total revenue ($100,000) and subtract the cost of goods sold ($50,000) to get a $50,000 gross profit.
To get net profit, we also want to subtract other expenses, giving us a net profit of $25,000. Finally, the net profit margin is the net profit of $25,000 divided by the total revenue of $100,000. That gives us a 25% profit margin, which is pretty high given the small business average.
Profit is typically recorded on a financial statement called the income statement or profit and loss statement. Here’s a sample profit and loss statement, so you can see how the numbers work together.
At the top of the statement, you’ll see the different types of business revenue that are streaming into the company. In the middle, you’ll see the costs that the company has to pay to operate and to produce the goods.
At the very bottom of the profit and loss statement, you’ll see the net income or net profit. In this example, the business’s net profit has steadily increased over a five-year period, which is a great sign. Another word that you’ll hear a ton as an entrepreneur?
Cash flow, our next business finance term. Cash flow accounts for nearly 80% of business failures, so it’s vital to understand this term well. And despite what many people think, cash flows not the same thing as profit. Cash flow is the amount of money flowing into and out of your business from operational, investing, and financing activities during a specific period of time.
Let’s take an example to see why cash flow is different from profit. Let’s say you own a company called Super Software LLC, and you sell $100,000 worth of product to Casey Client, but Casey isn’t actually prepared to pay you for three more months.
The sale immediately increases your business’s revenue and profitability if you use accrual basis accounting, but it does not immediately increase your cash levels. So technically, you could be cash flow negative until Casey actually pays you.
Cash flow is recorded on a financial statement called the statement of cash flows. In this sample statement of cash flows, the first couple columns are completed for you and you’ll see at the top that cash inflows to the business are listed. At the bottom, cash outflows from the business are listed.
If the cash on hand at the very bottom of the statement of cash flows is a positive number, that means the business is cash flow positive, and it’s a good sign. Assets, our next business finance term, include everything of value that your business owns.
This includes both tangible assets, such as a warehouse or equipment that your company owns, as well as intangible assets, such as the value of a patent or trademark. There are additional ways to distinguish assets as well. For instance, fixed assets are long term assets like the land that isn’t likely to be converted to cash anytime soon.
Current assets include things like cash, stock, and accounts receivable that are likely to be converted into cash within the year. Liabilities are the flip side of assets. Liabilities are everything that your business owes to a third party, such as a lender, a vendor, or an employee.
Examples of liabilities include business loans, accounts payable, which are amounts that you owe to vendors and suppliers, salaries that you owe to your employees, taxes that you owe to the government, and unclaimed dividends that you owe to your shareholders. Similar to assets, liabilities can be divided into long-term or fixed liabilities and short-term or current liabilities.
Current Liabilities are due within the year. Both assets and liabilities are recorded in one financial statement called the balance sheet. Here’s a sample balance sheet showing a company’s breakdown of assets and liabilities over a five-year period. You’ll see in the last row of the first box that this company’s asset position has improved over time.
The total liabilities for the business have also increased of late. But, this is balanced by a significant increase in the number of assets in 2019. This company has more assets than liabilities, which is a good sign. All right, so we’ve covered some business finance terms that you’re likely to see on your financial statements.
Now we’re going to switch gears and cover some debt and credit-related business finance terms, starting with FICO score is a widely used type of credit score, which is calculated by a credit rating agency called the Fair Isaac Corporation.
The FICO score ranges from 300 to 850, and the higher your FICO score is, the more likely you are to qualify for financing and to receive lower interest rates. Generally, a score above 670 is considered good. Here’s a graph showing how your score is calculated. As you can see, the FICO score is based primarily on whether you’ve borrowed responsibly in the past, and made loan and credit card payments on time.
The FICO score can take both personal and business debt into account. FICO score is a very important business finance term, especially if you plan on applying for business loans. Funder research shows that borrowers with the lowest or worst FICO scores have interest rates on average that are 60% higher than borrowers with the best FICO scores.
When borrowing money for your business, you might be asked to sign something called a personal guarantee. What does this business finance term mean? Well, a personal guarantee is a written promise that you make to the lender, backed by your personal assets, to pay back a business loan if the business is unable to pay.
A personal guarantee is usually part of your business loan agreement or contract. Let’s say you take out a $50,000 business loan, but your business doesn’t do as well as you expected, and you’re unable to make your payments. If you signed a personal guarantee, the lender can come after your personal assets, such as your home, car, or personal bank accounts, to recover the balance.
Broken down into two major types unlimited and limited. In an unlimited personal guarantee, the lender can recover 100% of the loan amount from your personal assets. In a limited personal guarantee, the lender is limited to recovering a specific dollar amount from your personal assets. Limited personal guarantees can be further broken down into two types several and joint and several.
These are commonly used terms for multiple-owned businesses. Under several limited guarantees, each business owner is responsible for a predetermined percentage of the debt, and a creditor can come after each business owner only for their respective portion of the business debt.
In contrast, in a joint and several limited guarantees, a business owner might become liable for the entire debt if other business owners don’t pay their fair share. With your personal assets on the line, signing personal guarantee can be risky, but it’s also usually required to receive a business loan.
Our advice is to apply for a business loan only if you’re sure that you’ll be able to pay back the loan on time. Or, you should have a plan B, like emergency savings, account that you can dip into to pay off the loan if needed. Our next business finance term, collateral, is closely related to personal guarantees.
Like a personal guarantee, collateral provides some security for the lender if your business is unable to pay back a loan. Collateral is an item of value, such as a piece of equipment or inventory that you pledge in exchange for a business loan. If your business defaults on the loan, the lender can sell off the item to recover the balance.
Now, lenders don’t like to go through the seizure and sale process, but it can happen if several months or years have passed since you’ve made a timely loan payment. Depending on the type of loan you have, you might not have to provide collateral that’s equal to the value of the loan. For example, a building that’s worth $100,000might be sufficient collateral for a $150,000 loan.
Some types of loans, such as equipment loans, are called self-securing loans, which means that you don’t need to provide additional collateral beyond the equipment itself. That can be very helpful for new businesses, which often lack a lot of collateral. And our last business finance term is annual percentage rate or APR. When applying for a business loan, most small business owners want to know one thing:
How much will this loan cost me? Well, annual percentage rate tells you how much you’ll pay for a loan over a one-year period, including all fees. That last point is important because a regular interest rate does not include fees. Only APR will tell you the cost of a loan with fees included. Application fees, packaging fees, origination fees, documentation fees, and other fees can often increase your loan cost significantly.
Here’s an example using Funder’s business loan calculators. If you have a $50,000, five-year loan within interest rate of 10% and a 2% origination fee, your APR is 10.88%, and you have to pay$14,741 in total interest payments to the lender. In contrast, if that loan has an interest rate of 15% and a 4% origination fee, the APR jumps up to nearly 17%, and you have to pay $23,370 in total interest payments to the lender.
That’s an almost $10,000 difference in the amount of interest you have to pay to the lender, so make sure you ask the lender for APR when shopping for a business loan. And those are our 10 must-know business finance terms, spanning accounting, financial statement analysis, and debt financing. Now that you understand these terms, you’ll be able to gain a competitive edge and better plan for your business’s success. Thanks.
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