Cash is king.
At some point, every business owner might have come across this saying. Cash, or capital, gives you the ability to deploy resources and build products and services. The managing of cash, however, can be the single biggest determining factor whether your business is able to sustain itself. At the same time, you also want to understand how profitable your business is, and how much more profit every sale earns you.
Here are 10 key financial terms that all business owners will eventually need to know to take your business to the next level, or power through difficult transitions in the middle of a global pandemic.
#1 Assets: Short-term And Long-term
Assets are things your company owns that have value and can be exchanged for cash. These include equipment and inventory or cash equivalents like convertible notes. Company assets can be further divided into short-term and long-term assets.
Short-term or current assets refer to assets that are expected to be conveniently sold, consumed, used, or exhausted through standard business operations usually with one year. These assets are most often liquid, which means they can be bought and sold easily.
Current assets include cash, cash equivalents, accounts receivable, stock inventory, marketable securities, pre-paid liabilities, and other liquid assets.
Long-term or non-current assets are usually illiquid, can be tangible or non-tangible and benefit the company for more than a year.
Long-term assets can include fixed assets such as your company’s property, plant, and equipment, but can also include other assets such as long-term investments, patents, copyright, franchises, goodwill, trademarks, and branding, as well as software.
#2 Liabilities: Short-term And Long-term
This refers to the debt that your company incurs while in operation. Liabilities can be short or long term, depending on when your debts are due.
Short-term or current liabilities are debts due within one year or a normal operating cycle.
Accounts payable may be one of the largest current liability accounts on your company’s financial statements, and it represents unpaid supplier invoices. Companies try to match payment dates so that their accounts receivables are collected before the accounts payables are due to suppliers. This is to avoid cashflow problems (explained later).
Long-term or non-current liabilities refer to long-term financial obligations that your company owes to creditors. These liabilities have obligations that become due beyond twelve months into the future.
Noncurrent liabilities include debentures, long-term loans, bonds payable, deferred tax liabilities and long-term lease obligations (rent).
A simple way to understand revenue is the sales that your company generates before expenses are applied.
It is important to understand that revenue (or sales) is not the only thing that you should focus on as a business owner. Managing expenses (keeping costs low) as well as your cashflow is also important for your business to be sustainable.
Revenue can also be divided into operating revenue — sales from your company’s core business — and non-operating revenue which is derived from secondary sources. As non-operating revenue sources are often unpredictable or nonrecurring, they can be referred to as one-time events or gains. For example, proceeds from the sale of an asset, a windfall from investments, or money awarded through litigation are non-operating revenue.
Expenses are the costs incurred in the operation of your business. Expenses may include rent, utilities, salaries, business supplies, raw materials and others. Expenses can be recurring and non-recurring.
Recurring general and administrative operating expenses are the normal, ongoing expenses required for your company’s chosen line of business.
Non-recurring expenses are considered a one-time expense that your company may not want to continue over time. An example would be a purchase of a property.
#5 COGS (Cost Of Goods Sold)
To understand profit, it will be important to understand the cost of goods sold.
Cost of goods sold (COGS) refers to the direct costs of producing the goods sold by your company. This amount includes the cost of the materials and labor directly used to create the good. It excludes indirect expenses, such as distribution costs and sales force costs.
COGS only applies to those costs directly related to producing goods intended for sale and should not be confused with operating expenses (see Expenses).
#6 Gross VS Net Profit
Gross profit = total revenue – COGS
Your gross profit is a profitability measure that evaluates how efficient your company is in managing your labor and supplies in the production process.
If you can lower your cost of producing your products (COGS) or sell your products for a higher price, you can increase your gross profit.
Net profit = total revenue – total expenses
Your net profit shows how much of each dollar collected by your company as revenue translates to profit.
On top of deducting the cost of producing your products, you should also deduct all other expenses that you incur to continue doing business. This helps you see how much of your revenue is going towards maintaining operating expenses versus improving your supply chain or product design and engineering.
Cash flow is very different from cash in the bank (capital): while the former indicates success, progress, and most of all profitability, the latter merely indicates that you have a war chest waiting to be deployed, whether through fundraising, crowdfunding or self-funding. Whether or not that translates to profitability is still a big if.
If more money is coming into your company than going out, you have positive cash flow. Congratulations! You get a return on your capital.
Conversely, if you have more money going out, you have negative cash flow. This is when you might need to see how to avoid burning up your capital in the coming months.
Thus, cash flow is an important indicator of the financial health of your business.
#8 Balance Sheet
The balance sheet is a statement of your company’s financial position shown in terms of assets, liabilities and ownership equity for a specific period of time. You’ll often hear the balance sheet referred to as a “snapshot of the company’s financial position”.
The difference between the total assets and total liabilities is known as the company’s equity or net worth. Basic accounting ratios determine that a company’s net worth is equal to its assets less its liabilities and should show you what your assets are after you add your liabilities and equity together.
An expensive asset, such as a building or laptop, is a long-term investment in your business. However, some assets (like furniture and vehicles) lose value over time due to age, wear and tear, or because they’re no longer useful. Depreciation lowers the value of assets.
You can account for depreciation for your company’s assets over time. Instead of subtracting the cost of the asset immediately, you can spread it across the asset’s lifetime, incorporating the decreased value of the asset as depreciation.
This is the share that you or your business partners own or have invested in your business, minus paid liabilities. This may also be called capital and may include capex or capital expenditure under fixed assets for long-term use, such as the building you bought for your office.
If your company is profitable, your equity as an owner increases.
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