Financial Literacy: A Cheat Sheet for Small Business Finance
If you are a small business / startup I bet you have encountered things you didn’t understand at first. It’s pretty much a given, right? Not everyone starting a business is a ‘serial entrepreneur’. Financial terminology often comes top of the list of known unknowns. From the fairly basic, like differences between cash and profit, to abbreviations like EBITDA and KPI ratios, there is a lot of information out there. It seems just jargon at first, but in the case of business finances, it’s jargon that carries meaning.
Finance is often seen as a difficult discipline, a closed book or black box. Something, in short, that you need an accountant for. And I can’t deny, there’s a lot of depth and complexity to finance. But in a lot of cases it’s just that the terms and concepts being used aren’t ones that are familiar to the vast majority of people. Understand this terminology, and financial jargon stops being a means of obfuscating information, and starts aiding understanding.
Back to basics – basic accounting concepts
Here are 14 basic terms you definitely need to know – they’re not as scary as they look!
Put simply, cash is real money, rather than the promise of money. It’s the cash you have in your bank account right now, the cash you are paying suppliers right now or the cash you are receiving from customers right now. Example: If you charge £100 for a product, but only receive that £100 10 days later when your customer pays you, then your cash only changes after 10 days. Until cash changes hands, it’s just a promise.
A unit is a term for something that you sell, generally used for types of items that you sell a lot of. Units track how much you sell, rather than the revenue they generate. A cupcake, a car, a magazine subscription or an hour of consulting could be a ‘unit’, depending on your business.
Stands for Cost Of Goods and Sales. These are direct costs associated with a sale – for example the materials required for a product, or the cost of delivery.
COGS is a type of variable cost – a cost that you pay which changes depending on another factor, often this factor is how much you are selling. The more sandwiches you sell, the more bread you need to buy.
As opposed to a variable cost, a fixed cost is one that remains the same over time (barring external factors like inflation) and generally does not directly contribute to a sale. Fixed costs include bills and many of the running costs of most businesses. Click here for a checklist of common fixed costs.
How much revenue you receive, ignoring any associated costs. There’s a big difference between turnover and profit!
National Insurance – salary isn’t the end of hiring someone. If you have an employee you will need to pay NI in addition to their salary. You can find the UK rates here: https://www.gov.uk/national-insurance-rates-letters/contribution-rates
Things the business owns, that have been paid for. There are many, many kinds of asset. As a rule of thumb, if something has value, is owned by the business and could be sold to meet a debt, it is an asset.
Depreciation is the reduction in value of an asset over time. This is generally due to wear and tear of the asset. Depreciation is recorded as a loss to the business on the P&L
Depreciation’s more obscure cousin, amortisation reduces the value of an intangible asset (a non-physical asset, such as a brand, licence etc) over a certain time period, often the ‘life’ of the asset (how long it lasts in a useful state). Amortise essentially means to write-off, meaning that whatever is written off does not have a financial impact on the business any longer. Amortising can give a more realistic impression of the business’ financial position.
Total assets minus total liabilities give you net assets. Generally, the higher your net assets the better, as it means the business can liquidate more cash if it needs to.
Sounds scary! But all it means is selling assets for cash.
A liability is something the business is liable to pay – either an outstanding debt or other financial responsibility that the business will be called upon to pay money towards. A common example is a loan.
Equity the value of the company’s assets, minus the company’s liabilities. What is left is usually a combination of the capital invested in the business, either by the owner, directors or shareholders, and any retained earnings the business has from previous activities.
The ‘big three’ financial reports are all different ways of viewing the financial picture of your business. Each approaches the business from a different angle and displays different, though inter-linked information.
The Cash Flow Statement shows the cash flowing into and out of the business. As we saw earlier with Cash, it shows when cash actually changes hands. It splits this cash out into different categories, such as cash received from sales, loans, the sale of equity or asset sales, or the cash spent on direct costs of sale, operating costs, salaries, or interest payments.
Income Statement (Profit & Loss, Income and Expenditure)
The Income Statement (known by many other names!) shows all of the businesses income and expenses, with the aim of showing when and how much loss or profit the business is making. The Income Statement also records other sources or profit or loss to the business, such as the increase or decrease in the valuable assets.
How is this different from the Cash Flow? While the Cash Flow records the time that cash actually changes hands, the Income Statement records the financial status of these transactions as either income or expenditure, regardless of when the payments occur. The cash flow also only looks at cash changes, and so does not pick up things like an asset losing value, where no cash changes hands.
The Balance Sheet is a record of the business’ Assets (what it owns, + cash), it’s Liabilities (what it owes) and the Equity that remains. It is a means of seeing how much of the business is funded by debt (liabilities) as opposed to capital and shares (Equity). Unlike other reports balance sheets are cumulative. Each column of the balance sheet is a snapshot of the business’ finances at that particular time, showing the progression in value of the assets, liabilities and equity that make up the business.
Financial planning terminology:
If you’re starting to get into the financial planning of your business, you might hear these three terms a lot…
The most troublesome one first! ‘Model’ has two meanings in planning…
1. The first is a description of how the business works. Often this is called a sales model. It describes how, in general, the business plans to be successful at selling.
2. The second is a financial model – a plan that contains everything pertaining to the business, usually looking ahead several years into the future. Models are designed to evolve with the business. This kind of model can be used to produce a financial forecast.
A financial plan for the future. A forecast looks at the business currently, and any trends that have developed in the businesses finances and then makes assumptions about how these will carry forward in the future.
Agreed upon amounts allotted for spending on different parts of the business. A budget is informed by a forecast.
More finance terms you should know:
Now, here are a few things it took me a while to get my head around. But if you’ve understood the terms above getting these should be easy going!
Income from sales minus the cost of making or delivering the product/service being sold (COGS).
Income after all of the businesses costs have been deducted.
Breakeven is the point at which the business’ revenue matches the costs required to generate that revenue. Imagine, I spend £1000 on stock purchase costs in month 1 and then have regular costs of £100 a month. I receive £200 every month in revenue. It will take me 10 months to have made £2000 revenue, at which time I will have spent £2000 to generate this revenue, so I break even in month 10.
Payback is similar to Breakeven. The ‘Payback Period’ is the time required for an activity (project, investment, etc) to pay back the money invested in it. This can be used to compare different activities and find out which has the quickest payback time. A key difference between this and breakeven is that payback could come in the form of a cost saving activity, rather than a revenue generating one. If a £1000 purchase can save the company £100 a month, it has a payback period of 10 months.
Earnings before interest, taxes, depreciation, and amortization. Clear and concise?! Hmm. When I started learning about finance EBITDA really stood out as a mystery, made-up term that seemed to be everywhere. Put simply, it’s what you earn (income) minus all costs to the business except the types specifically mentioned.
One of many ratios you will come across, Current Ratio is the most common. It is used to show how well the business could, in theory, meet its debts by selling its assets. This is worked out by dividing the business’ total assets by its total liabilities. The higher the ratio, the stronger the business is seen to be, as it can meet its debts more easily. What a ‘good’ current ratio is will depend on the business and its situation. Example – If a business has £1000 assets and £500 liabilities, it’s current ratio is 2. The business can easily liquidate assets to pays its debts if necessary.
Return On Investment – a simple* one to end with. ROI is a term not just used in the investing world, it applies to any financial expenditure. What return will I get for my money may be hard to quantify more some costs (better coffee for the office is priceless, not that I’m angling for anything…) but it’s an important question to ask of any major project and particularly advertising and marketing activities.
Learning financial language and how to apply it is all about understanding an interconnected web of terminology. Once you understand the simple terms your frame of reference expands, allowing you to construct more complex relationships between these things that until now, you didn’t even realise were a way businesses are measured. There’s always more to learn, but if you come across something you don’t understand don’t worry! Break it down until the terms start to make sense, then build it up again, learning what you need to on the way.