Business Finance Terms You Need to Know Before Starting Your Business
July 11th 2019 at 12:56pm Published by firstdownadmin
Running a business of your own is a constant struggle. You can make this struggle easier for yourself and the others involved by treating it as a learning curve. Every struggle and every tight spot you encounter as part of your business journey should be treated as a learning curve you should follow for further glory.
Regardless of whether you are just starting your business or have an already established small business that you want to take big, you should know all the business finance terms that will be thrown at you during your time as an entrepreneur. While you might know a bit about marketing terms, since they are inspired by the verbiage we use in our daily lives, finance terms are a bit hard to understand for most entrepreneurs.
Instead of feeling lost whenever you are discussing finance with your finance executives or an external stakeholder, you should make a conscious effort to make sure that you understand all the terms that are used in the world of business finance.
Here we make this learning curve easier for you by listing down some of the most common terms used in business finance by people around you. Go through these terms and build upon your understanding of how finance works in business.
1. Account Payables
If you are already running a small business, we expect you to know a bit about this term and the context that it is used. Account Payables is a term used as part of finance 101 training. This term represents your obligation to pay the debts and funding that you currently owe to suppliers and creditors. Account payable comes in your balance sheet under the header of current liabilities, as this is a liability for you, which should duly be paid back to the rightful owners or the funders.
2. Account Receivables
If you’ve understood the concept for account payables, you won’t have difficulty in understanding the concept for account receivables. Account receivables happen to be the exact contrast to account payables, which is why you wouldn’t have a hard time understanding them. This term is used to refer to the funding you have handed over to people or customers you work with. Account receivables are an asset for you, as this money can be returned to you at any given time in the form of cash.
3. Accrual Basis
The world of accounting has numerous principles, and accrual basis is just one of them. This principle of accounting is followed in the day to day operations of many businesses because it directly relates to how you record income and revenue. The principle of accrual basis states that you should record income and expenses only when they occur. Your income should be recorded only when it is earned and your expenses should be recorded in the books only when you make the desired payment towards them. None of these heads should be recorded before they happen.
Having discussed the concept of Accrual Basis, we now move on to the concept of Accruals. The term for Accruals follows on from the definition of the principle that we mentioned above. All such expenses that have been incurred, but haven’t yet been paid for or recorded in the business books are known as accrued expenses. To illustrate this further, let’s say you have to pay rent every month on your business premises. Now, the expense would be considered accrued when the time for the rent payment passes and you still haven’t made the payment. Accruals are considered as liabilities because they have a similar nature to accounts payable. You have to pay the rent at one given time.
This is one of the key business terms that you ought to know of. An asset is anything that currently has value and comes under your ownership. Regardless of whether it is intangible or tangible, the asset comes under the ownership of the business itself.
Business assets are grouped into two types; current assets and non-current assets. The current assets have a holding period of 1 year or less, while non-current assets have a greater holding period. What needs to be considered here is that both non-current and current assets form the value of your business. Current assets even have an important role to declare the liquidity of your business, as they are given high importance in every formula used for computing liquidity. Some examples of assets include; cash on hand, buildings, equipment, inventory, and accounts receivable. The asset should be under your ownership for it to truly come in your books of financial accounting and your balance sheet.
6. Balance Sheet
Since we’ve already briefly touched upon the balance sheet in the definitions above, we will fully understand what it is in this definition. A balance sheet is essentially a snapshot of all the information that you want to give about your business.
The balance sheet for your organization includes all the relevant details of your business’s net worth, among other things. The balance sheet is usually of high interest to stakeholders when you ask them to invest in your business.
Bookkeeping is the accounting process of recording every sale or transaction as it happens. You should jot down all of your transactions, revenue, expenses and other heads on a piece of paper so that you know how you’re doing as a business. It is hard to keep track without a proper bookkeeping approach.
Capital is another key term which acts as the lifeline of your business. Also known as ‘fixed investment’ capital is used to tell about the long term worth of any business. Capital is usually invested by the owner into the business when it is being formed. The capital is of importance to the business, as this is the oil that will be required for keeping the business afloat during times of need. The capital that you have invested in your business also gives an indication of how much wiggle space your business has if things go awry during a liquidity crunch.
9. Working Capital
Working capital is a different term than capital and the two should not be confused together. Working capital is usually the resources available to the business for handling all the day-to-day operations. All the revenue expenditures that you pay daily are to be financed through a set amount. Your working capital determines the funds you have for paying your day to day operations and keeping the business running.
10. Cash Flow
Cash is perhaps the most vital necessity for a business to operate or just remain existent. When it comes to cash, the most important term you need to know is that of cash flow. Cash flow determines the flow of cash to and fro the business. This will include all of the payments you are making and the revenue that you are receiving. Cash flow plays an important role in determining the liquidity of a business.
Let’s just a business has poor cash flow immediately after it first starts operations. This will mean that the business is unable to maintain good cash flow or a good balance of cash in hand or cash at bank. Poor cash flow should, however, not be confused with poor business performance. The performance of the business is a completely separate factor and should be treated separately. The cash flow of your business is important for identifying the flow of cash to and fro the business. Regardless of how much you are making in profit, the cash you have in hand at the end of the day is what matters. Profits cannot be utilized and are pretty much intangible. Cash can be utilized and is the tangible property you need for handling business operations. Additionally, poor cash flow might also lead to the need for a small business funding for your organization. It is when you have nothing left in the bank to spend on daily operations that you head for external financing options.
11. Cash Flow Projections
We have already discussed cash flow in detail above, so you ought to know everything in detail about it. Besides cash flow, we have the term cash flow projections which you might see being used by multiple people around you. Cash flow projections are used to identify the upcoming flow of cash in your business. You need to identify patterns within your business expenditure and earning. These patterns can then be used for identifying the future flow of cash in and out of the business. A good understanding of cash flows can help you properly finance your business. If you can identify and spot a financial or liquidity crunch before it happens, then you can take preemptive measures to lower the shock of going through one. Thus, cash flow projections are quite helpful for the business and those involved.
Depreciation relates directly to your non-current and fixed assets and operates as a contra asset. By a contra-asset, we mean that depreciation can directly reduce the value of your asset when it increases.
As your fixed assets, besides land, start being utilized, you will notice that they are losing value. Since accounting and finance are all about recording all kinds of expenses that you incur, entrepreneurs’ record depreciation as a constant expense. Rather than taking a sudden hit at the time of selling the asset off, entrepreneurs keep on deducting a specific sum from the asset over years of use. The specific amount you cut from the asset would be done through a fixed percentage on the cost of the asset or through a running balance method.
13. Fixed Asset
While we have already shed some light on this above in the definition of assets, it is best to mention them separately as well, knowing the value they play in how you run your business. Fixed assets are all non-current assets that you currently own and would most probably own by the end of the current year as well. This includes all items such as furniture, equipment, vehicle, and real estate. All fixed assets are subjected to depreciation because their value depreciates after a given time. However, the value for land might appreciate based on the economy, which is why it is treated differently.
14. Gross Profit
The gross profit is a major part of your income statement and is going to be of key interest to you when you first start your business. The value for gross profit indicates the markup that you’re making on your sales. If you’re in a merchandising business, it tells you about the money you’ve earned while buying and selling goods. The Gross Profit is generally computed by subtracting the value of all purchases from that of the sales.
15. Income Statement
The income statement is one of the most important documents that any funder or stakeholder will like to view before being associated with your business. An income statement is of such interest because it tells a lot about the profitability and current standing of a business. The income statement contains a detailed list of expenses, net expenses, sales and cost of sales. This gives any funder an idea of how the business is operating and whether they are worthy of financial investment or not. Additionally, the income statement also includes the net profit, which you can calculate after subtracting all expenses from the value of the gross profit that we talked about above. The net profit is then transferred to the financed by section of the balance sheet, where it works as the money that the business currently has.
Again this is something that we have talked about briefly above. The liability of your business is the legal obligation you have to pay all the debts you currently have. All your debts and accounts payables are known as liabilities.
The liquidity of a business is an indication of how quickly a business can turn all the assets currently owned by it into cash for paying off the debt it currently owes. The liquidity of an organization gives insight into the current cash standing of the business. It lets a business know how they stand in regards to cash and what should be done to improve this.
There are multiple formulas for calculating liquidity, each of which gives you a fresh take on the matter. To start with, you can calculate liquidity through the current ratio. The current ratio is computed by dividing all of your current assets with the value of your current liabilities. The answer to this formula would give you a basic understanding of your liquidity. The current ratio should be at least 2; anything less than that is a liquidity crunch. If you want an even better test of your organization’s liquidity, then the acid test ratio is your safest bet. The acid test ratio or the quick ratio follows the workings of the current ratio above but makes it even better by deducting the amount you have for inventory in the current assets. So, the formula for this ratio would be the total of current assets minus the value of inventory divided by the value of current liabilities. The value for inventory is subtracted because you will not be able to sell inventory off quickly in the time of a financial crunch. The answer for this formula should ideally be between 1.5 and 2. Anything less than that is a sign of a liquidity crunch, and you will have to head for a small business funding.
18. Statement of Cash Flow
We have talked about cash flow in detail above, so we expect you to know what it means. All of the inflows and outflows of cash, calculated as part of your cash flow are done through the statement of cash flow. The statement of cash flow is hence an official document that is kept for recording all of the expenses that you incur and all of the revenue and other incomes that you generate in the form of cash. By the end of the statement of cash flow, you will realize whether you have a cash surplus or loss during the given period.
19. Business Credit Report
Entering the financial world of business management, this phrase should be well understood to you. The Canadian economy works based on debt, as we see numerous financial instruments being traded around between consumers. Knowing that debt and financial instruments are the key aspects powering the economy forward, certain considerations are made to ensure your validity or reliability for a debt plan.
Your reliability for a debt option is measured through a business credit report or a credit rating. Multiple organizations check your credit history and rating to deliver you a report of your credit status. The credit report you have is based on the following heads:
- How you have followed repayment plans in the past?
- How much of your total debt do you consume?
- How many debt options have you gone for in the past?
- How is your credit score?
All of these factors go on to set the credit score for your business. Your credit rating plays an important role in ensuring whether you will get a small business funding or not. While banks place your credit score at the highest pedestal for ensuring whether you qualify for funding or not, other private venders are a lot more relaxed in this regard. You can get a cash advance from private funders online who are more willing to help give funding to you and understand the kind of conundrum that you’re going through.
20. Debt Financing
Carrying on from the above, debt financing is the option you take when you go for funding with interest payments. This kind of financing is characterized by how you have to return the principal amount with the addition of interest in periodic payments. You have to make sure that the repayment plan given to you by the funder is smoothly followed.
Debt financing includes all the borrowings you do from business credit cards, banks, merchant cash advances, small business fundings, lines of credit and invoice financing. This method of debt has to be repaid, and it gives you access to cash without compromising the sole decision-making power that you enjoy in your business.
21. Secured Funding
Most funders will secure collateral before handing over a personal funding to you. Collaterals are used in exchange for a wide variety of business fundings, which is why secured funding are the basic norm in the industry. Collaterals are assets that you add to funding option for securing the funding. In case you’re unable to make the payment, then your funder can use the collateral and sell it at fair market value and deduct the amount of their principal plus interest from it. Banks usually allow only secured funding because of how these are more convenient and plausible for them.
22. Unsecured Funding
Loans that aren’t backed by any collateral are known as unsecured funding. These funding usually pose a higher risk for the funder, as you have to pay back a higher cost of working capital on them. Credit cards act as a good example of unsecured funding, in comparison to some of the other options. Even some private funders online provide unsecured funding as they don’t require collateral to be provided for the funding to be approved. All of these terms will continuously be repeated in front of you if you’re starting your own business.
With the definitions now cleared, you’d be better able to understand them and the context they give.