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. Even if you hire an accountant and especially if you utilize accounting software, it’s still important to have 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.
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.
As part of your overall strategy—whether you’re a retail store, eCommerce business, or service provider—it’s vital to have a basic understanding of key 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.
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.”
Cash is the most liquid asset of an entity and thus is important for the short-term solvency of the company. The cash balance shown under current assets is the balance available with the business. This cash can be promptly used to meet its day-to-day expenses. It typically includes coins, currencies, funds on deposit with bank, cheques and money orders.
Thus, cash appears as first item under the account head “current assets” in the balance sheet as it is the most liquid asset of the entity. This is because all the items in the current assets account category are listed in the order of liquidity of the assets.
Cash and cash equivalents stood at Rs 15,987.70 million as of December 31, 2018 in the Nestle case study above. The company takes 12 months as its operating cycle for bifurcating assets and liabilities into current and non-current. This operating cycle is based on the nature of products produced by Nestle. Furthermore, it also depends on the time gap between the acquisition of assets for processing and their conversion into cash and cash equivalents.
2. Cash Equivalents
Cash equivalents are the result of cash invested by the companies in very short-term, interest-earning financial instruments. These instruments are highly liquid, secure and can be easily converted into cash usually within 90 days. Furthermore, these securities include treasury bills, commercial paper and money market funds. Also, these securities readily trade in the market and the value of such securities can also be readily determined.
Thus, one of the key cash management strategies entails that idle cash should not be locked up into unproductive accounts. Instead, surplus cash needs to be put into such marketable instruments.
3. Stock or Inventory
Inventories are the sum of items that are either:
- Stocked for the purpose of sale in the normal course of business (finished goods)
- In the production process and would eventually be sold (work-in-progress)
- Shortly be consumed in the manufacturing of goods that would be sold eventually (raw material)
It is important to note that the items forming a part of inventory are the goods that would be sold in the normal course of business. Thus, goods available for resale form a part of inventory in case of merchandising companies. Whereas, goods available as raw materials, work-in-process and finished goods form a part of inventory in case of manufacturing firms.
Raw materials consist of goods that are used for manufacturing products. Work-in-process refer to the goods that are still in the manufacturing process and are yet to be completed. Finally, finished goods refer to the items that are completed and are awaiting sale.
Now, cost of inventory includes all the costs that are necessary to bring the goods into such a place and condition that they are further sold. This means cost of inventory includes purchase cost, conversion costs, freight-in and similar items that relate to the above rule. However, following costs are excluded from the cost of inventory:
- abnormal waste of raw material, labor and overhead,
- storage costs,
- administrative overheads and
- selling costs
Therefore, various inventory costing methods have to used once the unit cost of inventory is determined. These methods are used to bring a systematic approach in determining the cost of inventory. This is because each unit of inventory has a different cost.
4. Accounts Receivable
Accounts receivables are the amounts that a company’s customers owe to it for the goods and services supplied by the company on credit. The accounts receivables are presented in the balance sheet at net realizable value. These amounts are determined after considering the bad debt expense.
Now, increase in the bad debt expense leads to increase in the allowance for doubtful accounts. Therefore, net realizable value of accounts receivable is calculated. Net realizable value of accounts receivable is nothing but the difference between gross receivables and allowance for doubtful debts. Thus, it is these accounts receivables at net realizable that the firm expects to collect from its customers.
Now, there can be cases where accounts receivable have to be removed from the balance sheet as such accounts cannot be collected from the customers. Thus, both gross receivables and allowance for doubtful accounts have to be reduced in such scenarios. Furthermore, companies have to identify issues with their collection policies by comparing accounts receivable with sales.
5. Marketable Securities
Marketable securities are the investments made by the company. These investments are both easily marketable as well as expected to be converted into cash within a year. These include treasury bills, notes, bonds and equity securities.
Thus, these trading securities are recorded at cost plus brokerage fees once these are acquired. However, the value of these securities might fluctuate rapidly. This is because such securities are are readily marketable. Therefore, these trading securities need to be recorded at their fair value post the initial acquisition. And the change in their value therefore reflects in the income statement of the company.
Furthermore, the details with regards to such investments are mentioned in the financial footnotes.
6. Prepaid Expenses
Prepaid expenses refer to the operating costs of a business that have been paid in advance. Thus, cash reduces in the balance sheet at the time when such expenses are paid at the beginning of the accounting period. Simultaneously, a current asset of the same amount is created in the balance sheet by the name of prepaid expenses.
However, these prepaid expenses eventually turn into expenses from current asset. These expenses get converted at a time the business derives benefit from such an asset as per the matching principle of accounting.
7. Other Liquid Assets
Other current assets include deferred assets. These assets are created when the tax payable exceeds the amount of income tax expense recognized by the business in its income statement. This can happen in situations where
- expenses or losses are shown in the income statement before they are actually tax deductible or
- revenues or gains are taxable before they are shown in the income statement.
Thus, this deferred tax asset gets reversed over a period of time. It gets reversed at a time when the expense is deducted for tax purposes. Or revenue or gain is recognized in the income statement.