Finance Lingo Every Businessperson Must Know
As a business owner, you want to know what goes on in and around your business. This way, you can make informed decisions when needed to and this is why you must understand the basic accounting and finance terms.
What about the accountant, what’s their job?
Well, first off, it’s your business and you want to take full responsibility for it including the decisions you make. Also, it makes you a versatile business person. In addition, you don’t want to embarrass yourself in front of fellow business people as they throw around these basic terms.
With that said, let’s get started with the financial terms you must know.
Accounts Payable and Accounts Receivable
In the simplest terms, accounts payable is the money you must pay others or otherwise owe them. In contrast, accounts receivable is the money your clients owe you or rather what they must pay you.
While this explanation makes it easy to understand, many small businesses falter in their meaning. Often, clients will receive a notification of accounts receivable through an invoice. For the business owner, they’ll list this payment as an asset on their balance sheet.
If you want to separate the two, understand your payable is another person’s receivable. This means if you pursue your accounts receivable, you’ll get in touch with the client’s accounts payable department. The same goes for when you want to make a payment to your vendor. You’ll talk with the accounts receivable on their end.
By understanding these terms, you’ll save a lot of time bouncing from one department to another during transactions with your vendors and clients.
Equity is what you own in the business. It can be in the form of money, other valuables invested in the business or both. It also includes all the earnings acquired by the business from its inception.
A different definition is a difference between what the business owes also known as liabilities and what the business owns also known as the assets.
If you have a positive difference, then it means your business is healthy. On the other hand, if you have negative equity, then it means one or a combination of multiple factors. For example, you may have too much debt, you may be drawing a lot of money from the business or the business isn’t profitable enough to sustain operations.
With positive equity, you can attract potential investors, buyers and lenders if you want to expand the business or sell it.
Of all the accounting terms, this is probably what you must focus on the most. In simple terms, the burn rate represents the speed at which your business spends its money.
To calculate your burn rate, select a timeframe, say a quarter and then deduct the amount of money you’ll have at the end of this period from the amount you had at the start of the quarter. Afterward, divide the result by the number of months in the duration. The end result is your burn rate.
Let’s use a real-life example. Let’s say you decide to use a quarter as the duration and start at $12,000 and end up with $6,000 in your bank account. This means your business used up $6,000 in the 3-month period. Divide the usage ($6,000) by the 3 months and your burn rate will be $2,000 per month.
Understanding your burn rate is critical to managing your cash flow. With a negative burn rate, it means you have huge cash reserves, which is good for your business. However, you break this only when you want to expand your business. Otherwise, having a positive burn rate is detrimental to your business.
Cost of Goods Sold
You also want to keep an eye on the cost of sales or cost of goods sold. Others use the term cost of production. Whichever term you decide to use, the bottom line is understanding what it means, which is the cost involved in producing a certain product or service. In fact, the cost of goods sold directly affects your profit margin.
For example, your business may produce $1 million in a financial year. These numbers sound impressive, don’t you agree? However, if your cost of production is $900,000, then it means you only realize a profit of $100,000 which also translates to a 10% profit margin. Don’t forget you have salaries to pay, taxes and utilities just to mention a few of the expenses.
As a business owner, you want to reduce the cost of production in order to realize bigger profit margins while maintaining the same number of sales. Furthermore, more money in the account means you can start thinking about expansion.
Draws and Distributions
This will depend on your business structure and organization, especially when it comes to whether you appear on the company’s payroll. Nevertheless, many business owners pay themselves using draws and distributions.
Note that the draws and distributions will not appear on your company’s profit and loss statement. Instead, the payouts will appear as deductions in the business equity.
This is a common term you’ll encounter when going through your profit and loss statement and may cause a bit of a headache. This is why. Sometimes, the figure indicated as profits may not represent bank account balance. It could be higher or lower.
According to accounting and bookkeeping, the difference between the business operating expenses, depreciation and interest expenses, and the cost of sales and income is what is referred to as net profit. You must also keep in mind that cash flow activities such as debt payments and draws and distributions won’t appear on this statement.
You must also know you’ll be taxed based on your net income and not from the money left after clearing debts or taking distributions or draws. Although this will depend on the tax structure. Therefore, it’s critical to understand your tax responsibilities by consulting with a certified accountant.
In the business world, a liability represents what a business owes. In other words, debt. It could be an instant realistic loans, payroll taxes, sales or credit card balance.
The liabilities will appear on your balance sheet instead of the profit and loss statement. In addition, you’ll pay off these liabilities over a certain period by reducing the overall amount due as a liability while at the same time reducing the amount of money in your checking account.
It’s important to note liabilities aren’t bad. However, you want to make sure they don’t exceed the assets. If this happens, you’ll be a tight financial situation if your sales don’t do too well yet you need money to finance a certain project.
Return on Investment (ROI)
The return on investment is a simple analysis aimed at finding out the financial performance compared to the time or money invested in a certain product or service.
For instance, if you spend $1,000 on a marketing campaign and as a result of this campaign, you gain sales worth $10,000, then your return on investment is $9,000. This is calculated by subtracting the money spent on the campaign from the sales.
You can also calculate the ROI as a percentage. This you can do by taking the gross returns, $10,000 and divide it by the money invested, $1,000 and multiply by 100. In this case, the percentage ROI is 1,000%.
Calculating the ROI on each business product and service helps you to understand which products and services are bringing in the money and which aren’t.
Generally Accepted Accounting Principles (GAAP)
These are the principles which guide accountants and bookkeepers when doing their financial reporting and accounting. Being GAAP compliant is important for publicly traded companies, although investors and lenders will also want to see GAAP compliant reports so they can make decisions.
However, you also want to follow GAAP for your small business. This way you’ll develop these good accounting habits, even as you grow. This is possible through the help of a certified public accountant.
Knowing these basics doesn’t make you an outright financial expert. However, it makes your conversations with other business people much easier. In addition, it’ll help you oversight your business operations, thereby increasing the chances of success.
What’s more, during the initial stages of your business, you’ll be required to work in different positions in order to keep your doors open. Knowing and understanding these terms will make your job easy.