When you’re running your own business, you have a lot of responsibilities, and it can seem overwhelming, especially when you’re first starting out. It’s easy to get caught up in day-to-day operations without taking a step back to analyse your financial situation. But as a small business owner, understanding your finances is fundamental to your success.
You don’t need an accounting background to effectively manage your finances, but you should at least be financially literate. To make sure you have the basics, we’ve outlined the need-to-know components of financial literacy for small business owners.
Put simply, accounts payable is the money you owe. It is a record of all of your business’s unpaid obligations such as invoices, bills, and other liabilities owed to suppliers and creditors. It includes things such as due tax payments and utility bills. It can be referred to as A/P for brevity.
Accounts receivable is money owed to you. It is a record of invoices you issued to customers for services rendered or goods sold. These customers can be considered debtors as their invoices represent a short-term debt to you.
Acquisition is the purchase of one company by another. A buying company purchases most or all of a target company’s shares, enabling the buying company to make decisions on how to run the business of the target company. There are many reasons between a buying company and a target company to come to an agreement for acquisition, such as for growth, obtaining technology, or buying up competition.
Assets are tangible or intangible items that have value or generate benefits, such as revenue, for your business. Examples of tangible assets include factory equipment, buildings, and vehicles. Examples of intangible assets are intellectual property and brand names.
Your balance sheet is like a financial snapshot of your business at a specific point in time. It reflects what your company owns (assets), what it owes (liabilities), and its net worth (owner’s equity). It’s called a balance sheet because it balances — your assets must always equal your liabilities plus owner’s equity. It may also contain data from previous years so you can track your company’s performance and figure out ways to improve in the future.
Bank reconciliation refers to ensuring that your cashbook records match your bank statements.
Bookkeeping is a process for recording all financial transactions of a business.
First things first, you need to create a budget. Doing this allows you to track your income and expenses closely each month to make sure you’re bringing in more money than you’re spending. A budget gives you visibility into your financial picture. Then you can identify whether you need to make adjustments to maintain a healthy profit margin. To get started, you need to look at your financial data from previous months (or industry standards if you’re just starting out), which helps you forecast your income and expenses so you can plan for the future.
The net worth of a business from its cash accounts, assets, investments, and others. In general, it is associated with cash being put up for investment or productive work.
This term reflects the increase in value of an asset, typically when an asset sells above its original purchase price.
Cash flow is the amount of money you have coming into and going out of your business, which affects your liquidity. As a small business owner, it’s critical to manage your cash flow so you can predict how much money is available to you at any given time. To help manage your cash flow, you should reference your cash flow statement, which is used to report cash generated and spent during a specific accounting period. Having this information helps you match up your income to when you owe money. If you have slower months, tracking your cash flow also helps you know when you need to set aside extra money, so you’re not left short when bills are due.
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It is an asset used as security for a loan. In the case of failure to pay back the loan, the lender may acquire the collateral to recoup its losses.
Compound interest is interest on a loan calculated based on the principal and previously accumulated interest.
Cost of Goods Sold (COGS)
COGS are the direct costs related to producing your products and services. These include ingredients or raw materials, and labour. COGS does not include other expenses such as sales and marketing, distribution costs, etc. It is deducted from your revenues to calculate your gross profit/gross income.
Debt-Service Coverage Ratio
It is the ratio of your cash available for servicing debt payments.
Depreciation is the loss in value of an asset, such as equipment and vehicles, over time. In accounting, it represents how much of an asset has been used up in relation to the benefits you gained from using it. It is an expense reflecting a portion of the asset’s total cost over its useful life. Allocating the costs of assets this way is useful for tax and accounting, as it affects how profits are calculated. There are many types of depreciation depending on the business, equipment, regulation, and others.
Dividend is the amount paid back to shareholders from a company’s profits according to the number of shares held.
Earnings Before Interest, Taxes, Depreciation, and Amortisation, or EBITDA is the measure of a company’s overall financial performance. EBITDA is a measure of profitability.
Economies of Scale
Economies of scale are advantages brought about by production efficiency. For example, increasing production and lowering costs means that the costs are spread over a large number of products that can be sold at more competitive prices. This confers certain advantages to larger businesses than smaller ones due to the former’s capability to invest in streamlining its operations.
In the case of liquidation, equity is the value returned to shareholders if all of the company’s assets were liquidated and all of its debts and liabilities paid off. In the case of acquisition, it is the company’s sale value minus liabilities owed that were not transferred to the new owner.
Fixed costs are those that do not change with an increase or decrease in the amount of goods or services sold or rendered. Some examples include rental payments, salaries, depreciation. Fixed costs are in contrast with variable costs.
Fixed-income securities are investments that provide fixed, periodic interest until maturity. Examples of fixed-income securities include treasury notes, bonds, and certificates of deposit, among others.
Interest that does not change throughout the term of the loan. It is calculated as a percentage paid on top of the principal.
Goods and Services Tax (GST)
GST is a broad range value-add tax on most goods and services consumed locally. It is applied on top to the price of certain goods and services and paid for by customers, but businesses have to remit them back to the government.
Gross income is the total revenue you earn from all sources (your products and services) minus the cost of goods sold. It reflects how efficiently you use your labour and materials in production. It does not account for other expenses and deductions, such as taxes, withholding, depreciation, among others.
A guarantor is someone who promises to pay a debt in case a borrower defaults on his obligation. Guarantors pledge their own assets as collateral. There are many types of guarantors.
An agreement allowing a borrower to withdraw money from an account up to a pre-approved limit. Money can be taken out until the limit is reached, and as the debt is repaid, money can be taken out again without needing to open another line of credit.
Liquidation is the process of bringing to an end a business that has become insolvent, meaning it cannot pay its obligations and liabilities. The company’s assets are liquidated and used to pay creditors and shareholders.
Net income reflects the actual profit of your business after relevant expenses and deductions have been accounted for.
Operating income is the company’s gross income, which is total revenue minus cost of goods sold, minus all other operating expenses. Operating expenses include wages, depreciation, office supplies, and utilities.
Profit and loss statement
A profit and loss statement, also known as a P&L statement, income statement, or revenue statement, is a financial statement that details the amount of profit or loss over a specific time period, usually a month, fiscal quarter, or year. While the complexity of this statement can vary depending on your business type, don’t let it overwhelm you. In its simplest form, the goal of this statement is to look at your total sales minus your total costs to determine your net income. By reviewing this document regularly, you can analyse changes in your bottom line and decide if you need to make changes to increase profitability.
Return on Investment (ROI)
ROI is a simple metric to evaluate the efficiency or profitability of an investment. It is a way to indicate the return of the money invested into the businesses. It can be calculated as (Current Value of Investment - Cost of Investment) / Cost of Investment.
Variable costs are expenses that change in proportion to business activity in the manufacture of products or rendering of services. If production or related activity rises or falls, so do variable costs. Examples of variable costs are ingredients and raw materials. Variable costs are in contrast with fixed costs.
Working capital, or net working capital, is a measure of a company’s liquidity. Roughly speaking, it is the company’s available cash or liquidity for use in day to day operations.
When it comes to small business finances, there’s a lot to know, but understanding these terms empowers you to take control of your finances. If you can read basic financial statements, you can make informed financial decisions that help you successfully manage your business.