Whether you just launched your small business or have been running it for years, you need to stay abreast of important financial terms and understand how they affect your organization. Armed with this knowledge, you’re better prepared to make sound business decisions that ensure your company’s financial growth and stability.
April is Financial Literacy Month, which makes it the perfect time to review these 10 key financial terms every small-business owner should know.
An asset is something your company owns. They generally refer to tangible items — like cash, equipment, and property — but assets can also cover intangible things like trademarks and stocks. When buying things for your company, remember that while some assets appreciate over time, others depreciate. When possible, invest in assets that maintain or increase in value.
2. Working Capital
Working capital is the amount of money your small business has on hand to invest or to buy products or services necessary for its operation. Businesses that are cash poor can accumulate debt quickly because they often have to borrow money to continue operation or risk going out of business. Knowing how much working capital you have at any time can help you avoid debt and keep your business in the black.
3. Burn Rate
It costs you a certain amount of money to run your small business every month — and this amount is referred to as your burn rate. It’s important to know what your burn rate is so you can keep at least six months in reserve for operating capital. This reserve will help you get through unexpected slow periods without incurring a large amount of debt.
4. Profit and Loss
Your profit and loss statement (commonly referred to as a P&L) is an important component of your company’s financial plan. It lists your business’s income, expenses, gains, and losses for a specific period — usually per quarter or year. Over time, you can use your profit and loss statements to make realistic earnings projections, which in turn will help you make plans for the future and set earnings goals.
5. Balance Sheet
A balance sheet is an invaluable financial tool. It provides you with a snapshot of your business’s net worth and gives you an overview of its financial status — including liabilities, assets, and equity. Review your balance sheet at least once per quarter. This gives you the chance to quickly spot potentially negative trends and correct them before they impact your company’s financial well-being.
6. Accounts Receivable
“Accounts receivable” refers to money customers owe your small business for goods or services. It is considered an asset on your balance sheet and is often listed as A/R. It is important to track accounts receivable to ensure you’ve billed your customers, and to ensure that they pay you promptly for your goods or services. If they don’t, your cash flow can take a big hit. Good accounts receivable practices can help minimize backlog and keep your business on track.
7. Gross Margin
Your gross margin is expressed as a percentage and reflects how much money your company retains on each dollar. You can calculate your gross margin by subtracting your cost of goods sold from your total revenue, and then dividing that amount by your revenue. Knowing your gross margin allows you to set a price point for your product that will help your business remain profitable.
8. Breakeven Analysis
A breakeven analysis identifies when your company’s sales revenues will equal its expenses. Creating a breakeven analysis can help you evaluate your revenue model and make adjustments as necessary. An adjusted breakeven analysis helps identify the point at which your sales will not only cover your expenses, but also allow you to pay off debt, pay yourself, or hire more employees.
9. Equity Compensation
Startups that are low on cash and can’t offer competitive salaries often use equity compensation to help attract and retain top-quality employees. Equity compensation is non-cash compensation that represents a type of ownership interest in the startup — typically, companies offer stock options. There are different equity compensation models, each with their own legal and tax implications. Be sure you are aware of the pros and cons of equity compensation if you are considering this route.
Forecasting is the process of looking at your company’s historical financial data to predict future business trends. Forecasting plays a critical role in helping you develop realistic budgets and prepare your business and staff for especially slow or busy periods.
Without financial literacy, you could make decisions that undermine your company’s success. Keep these terms handy, and refer to them often. Continually educate yourself on all aspects of business operation so you can understand your company’s financial health, and learn how to strengthen it.