Last updated on October 14th, 2019 at 08:12 am
Entrepreneurs go into business with a variety of pre-existing skills. Some are natural salespeople, while others have the ability to come up with ideas that sell themselves. But while there may be a handful of entrepreneurs who are truly financially savvy, the majority cringe at the thought of preparing financial statements and managing the books of their small business.
Business owners who struggle with finances should definitely hire an accountant, or utilize accounting software to make things easier. However, while it may be wisest to depend on expert help when it comes to the nitty gritty, it’s still important to have at least a basic understanding of the inner workings of your company’s finances.
As such, there are some basic financial terms every entrepreneur should know as their business grows. These terms may come up in meetings with potential investors, partners, and clients, so it’s important to be aware of them and to understand how they might affect your business.
Here are 10 essential finance terms every entrepreneur needs to know.
First on the list of financial terms, assets are the economic resources a business has. In a broad sense, assets include everything your company owns that has some economic value. These are generally broken down into six different types of assets.
In this asset class, you would include things that can be easily converted into cash. Examples of assets in this category include stock holdings, inventory, short-term investments, marketable securities, fixed deposits, the balance in your business’s checking and savings accounts, bills receivable, and prepaid expenses. Because this type of asset can be quickly turned into cash, it’s also often termed “liquid assets.”
Also known as long-term assets or non-current assets, these are things that are of a fixed nature because they cannot be easily converted into cash and often require complex procedures and a significant amount of time before you can have their cash value in hand. For instance, fixed assets would encompass things like land, real estate, machinery and equipment, and furniture.
As the name implies, tangible assets are those assets that you can see and touch. This can include items that may also be referred to as current or fixed assets. For instance, cash — a current asset — is a tangible asset because it’s something you can physically touch. Most fixed assets are also tangible assets for the same reason. Land, real estate, machinery, equipment, and furniture are, after all, things you can see and touch.
These are the opposite of tangible assets, and include any assets that are, well, not tangible. Examples of intangible assets include things like franchise agreements, patents, brands, trademarks, and copyrights.
Although these things might not seem like they provide any economic benefit upon first consideration, business owners can reap monetary rewards from their use. For instance, a company’s trademark or brand can aid in the market and sale of its products. If you’ve ever bought an item strictly because of its brand, that company converted its intangible asset — its brand — into sales revenue.
These assets are those that are required for a business to complete its day-to-day functions. In other words, these are things that a company uses to produce its product or service and can include fixed and current assets, as well as tangible and intangible assets. Some of the most common items included in this category are cash, a company’s bank balance, inventory, and operating machinery.
Finally, non-operating assets are those that are not critical for a company to provide its product or service, but which are nevertheless essential to establish and run a business. For example, many intangible assets fall into this category, such as brands, trademarks, and patents.
If assets are the resources your company owns that contribute to its economic value, liabilities are its exact opposite. In fact, liabilities are just that — things your company is responsible for by law, especially debts or financial obligations.
For example, any debt accrued by a business in the course of starting, growing, and maintaining its operations is a liability. This could include bank loans, credit card debts, and monies owed to vendors and product manufacturers.
Liabilities, like assets, can be divided into subcategories. The two primary types of liabilities are often referred to as current liabilities and non-current liabilities.
This type of liability refers to immediate debts that must be repaid within one year. For example, money owed to suppliers or vendors would be a current liability.
Also referred to as long-term liabilities, this category encompasses debts or obligations that your company must repay in over a year’s time. For example, non-current liabilities would include things like business loans, deferred tax liabilities, mortgages, and leases.
Bringing the two above terms together, we arrive at your company’s balance sheet. This document subtracts your company’s total liabilities from its total assets in order to arrive at your company’s net worth.
Again, assets would include the current and fixed assets your company has on hand. Meanwhile, liabilities would include outstanding debts or obligations. By subtracting what you owe from what you own, you can determine your company’s net worth, and arrive at a comprehensive snapshot of the company’s financial situation at a given moment.
According to Section 162 of the Internal Revenue Code (IRC), business expenses are any cost that is “ordinary and necessary” to run a business or trade. These expenses are the costs your company incurs each month in order to operate, and include things like rent, utilities, legal costs, employee salaries, contractor pay, and marketing and advertising costs. To remain financially solid, businesses are often encouraged to keep expenses as low as possible.
5. Accounts receivable
Accounts receivable (A/R) is the amount that clients owe to a business. Usually the business notifies the client by invoice of the amount owed, and if not paid, the debt is legally enforceable. On a business’s balance sheet, accounts receivable is logged as an asset.
6. Cash flow
Your cash flow is the overall movement of funds through your business each month, including income and expenses. For instance, cash flows into your business from clients and customers who purchase your goods or services directly, or through the collection of debts in the form of accounts receivable. On the other hand, cash flows out of your business to pay expenses like rent, utilities, taxes, and accounts payable.
7. Cash flow statement
Businesses track general cash flow in a cash flow statement to determine long-term solvency, or their ability to pay their bills. A cash flow statement shows the money that entered and exited a business during a specific period of time, and helps determine whether a company is solvent or insolvent — meaning whether it can pay its bills or not.
Similar to your personal checking account, if more money is coming in than going out, your company is considered cash flow positive. On the other hand, if you have more money going out than coming in, your company might need to cover any cash flow shortage with a loan or line of credit.
8. Profit and loss
To remain financially healthy, a business must regularly generate more revenue from the sale of its product or service than it costs to make that product or service. Say it costs a company $2 to make a T-shirt, but that company sells the T-shirt for $10. In this case, the company’s profit is $8. On the other hand, a loss is money that a company, well, loses. For instance, if a T-shirt is stolen or destroyed and can no longer be sold, it would be counted as a loss.
9. Income statement
The income statement is where you analyze your company’s profits and losses. As such, it should come as no surprise that the income statement is also commonly referred to as the “profit and loss statement.”
This document summarizes the profits and losses incurred during a specified period, which is usually a fiscal quarter or a full calendar year. As such, it provides important information about your company’s ability to generate profit by increasing its revenue, decreasing its losses, or a combination of both.
10. Net profit
In accounting jargon, your net profit might also be referred to as net income or net earnings. And because it’s usually found on the last line of a company’s income statement, it’s often also called the bottom line.
But just what is it? Well, this is the total amount a business has earned or lost at the end of a specified accounting period, usually a month.
To determine your net profit, you would subtract all your business expenses from your total sales revenue in order to determine just how much money your company has earned above and beyond the cost of producing and selling your product or service. Net profit is usually used to determine whether a business’s earnings are increasing or decreasing.
Putting it all together
As an entrepreneur or small business owner, you likely didn’t choose to run your own company solely for the joy of creating and analyzing financial statements. The good news is, there are accountants and special tools available to help you manage your books. However, even if small business accounting isn’t your first love, that doesn’t mean you should ignore it entirely.
It’s important to know at least a few basic financial terms so that you have a grasp on how your company is faring financially. Additionally, being at least a bit financially savvy is always helpful when discussing your company’s past and future growth with colleagues, potential clients, and investors.
By maintaining some oversight of your company’s operations through financial reports and budget maintenance, you can increase its chances of success — and continue doing what you set out to do in the first place: grow your business.