Business Terms You Should Know
Whether you're balancing your books, analyzing financial statements, or applying for a business loan, there are a bunch of business finance terms that entrepreneurs need to get familiar with.
Key Takeaways
Understanding these terms, will help you gain a competitive edge and better plan for your business's success.
The 10 most important business finance terms…
Accrual Basis Accounting
As a small business owner, it's important to know where your company stands financially at all times. To understand what's going on with your company. You'll be balancing your books typically on a monthly basis, either yourself or with the help of a bookkeeper or accountant, you'll need to make an important decision at the outset.
Do you want to follow accrual basis accounting or cash basis accounting?
The decision impacts when revenue and expenses are recorded on your books so it can also impact income and profitability estimates for your business. accrual basis accounting recognizes revenue when it's earned, and expenses when they're built.
Let's take a simple example. Let's say you have a landscaping business called Awesome landscaping Corp. And you book a job to design Casey Customers Garden on July 1. Casey pays you on July 15 using her credit card. When will this revenue be recorded?
Under accrual basis accounting the revenue will be recorded on July 1 because that's when you booked the job and made the sale in order to prepare for the job.
Let's say you also place an order for landscaping supplies with your vendor on July 3. The vendor hands you an invoice that same day, July 3, but you only pay it using a check on July 10. When will this expense be recorded under accrual basis accounting?
The expense will be recorded on July 3 because that is when the vendor billed you.
The other accounting method cash basis accounting is our second business finance term.
Cash Basis Accounting
Under cash basis accounting, revenue is recognized when it's received and expenses are recognized when they're paid. Most small business owners use cash basis accounting because it's simpler than accrual basis accounting.
Let's use the same landscaping example to see how cash basis accounting works. Let's say you own awesome landscaping corporation and you book a job with Casey Customer on July 1. Casey pays you with a check on July 15. And you deposit the check that same day. When will this revenue be recorded?
Under cash basis accounting the revenue will be recorded on July 15 because that is when you actually received and deposited the check from Casey.
You also placed an order for landscaping supplies with your vendor on July 3. The vendor hands you an invoice that same day July 3, but you only pay it on July 10. When will this expense be recorded?
Under cash basis accounting the expense will be recorded on July 10, because that's when you actually paid the invoice.
Next we're going to cover some business finance terms that you're likely to come across when analyzing financial statements either on your own or with the help of your accounting or tax professional. For example, you'll spend a lot of time as a business owner analyzing profitability.
Profit
Profit measures how your business's revenue compares to your company's costs. There are several different measures of profit including: gross profit, net profit and net profit margin.
Gross Profit is your business's total revenue minus the cost of goods sold. The cost of goods sold is simply the expenses associated with producing and selling your goods.
Net Profit is basically your bottom line. It takes gross profit one step further by subtracting all expenses from your revenue, including cost of goods sold, operating expenses, taxes and interest. If your net profit is a positive number, then your business is in the black or operating it again. If your net profit is a negative number, your business is in the red or operating at a loss.
Net Profit Margin takes your net profit and divides it by total revenue. Net Profit Margin differs from industry to industry, and is a good indicator of how your company is performing relative to competitors.
Let's take an example using awesome landscaping Corporation. Let's say the business generated $100,000 in revenue last year cost $50,000 last year to offer their landscaping services and other expenses for the year totaled $25,000. Is awesome landscaping profitable? Yes it is. And here's why:
To calculate gross profit for Awesome Landscaping Corporation, we will simply take total revenue of $100,000 and subtract $50,000, the cost of goods sold, to get a $50,000 gross profit.
To get net profit, we also want to subtract other expenses, giving us a net profit of $25,000.
Finally, the net profit margin is the net profit of 25,000 divided by the total revenue of 100,000. That gives us a 25% profit margin.
A 25% profit margin is pretty high given the small business. Average profit is typically recorded on a financial statement called the income statement or profit and loss statement.
Cash Flow
Another word that you'll hear a lot as an entrepreneur is: cash flow. Cash flow accounts for nearly 80% of business failures. So it's vital to understand this term well. Cash flow is not the same thing as profit. Cash flow is the amount of money flowing into and out of your business from operational investing and financing activities during a specific period of time.
Let's take an example to see why cash flow is different from profit. Let's say you own a company called Super Software LLC, and you sell $100,000 worth of product to Casey Client. But Casey isn't actually prepared to pay you for three more months. The sale immediately increases your business's revenue and profitability if you use accrual basis accounting, but it does not immediately increase your cash levels. So technically, you could be cashflow negative until Casey actually pays you. Cash flow is recorded on a financial statement called the statement of cash flows.
Assets
Assets are everything a value that your business owns. This includes both tangible assets such as a warehouse or equipment that your company owns, as well as intangible assets such as the value of a patent or trademark. There are additional ways to distinguish assets as well. For instance, fixed assets are long term assets like:
land
Current assets include things like:
cash
stock
accounts receivable
Liabilities
Liabilities are the flip side of assets. Liabilities are everything that your business owes to a third party such as a lender, a vendor, or an employee. Examples of liabilities include:
business loans
accounts payable, which are amounts that you owe to vendors and suppliers salaries that you owe to your employees
taxes that you owe to the government and unclaimed dividends that you owe to your shareholders
Similar to assets. Liabilities can be divided into long term or fixed liabilities and short term or current liabilities. Current liabilities are due within the year. Both assets and liabilities are recorded on a financial statement called the balance sheet.
FICO Score
If you've bought a home or car recently, you might already know this term. FICO score is a widely used type of credit score, which is calculated by a credit rating agency called The Fair Isaac Corporation. The FICO score ranges from 300 to 850. The higher your FICO score is, the more likely you are to qualify for financing and receive lower interest rates.
Generally, a score above 670 is considered good. The FICO score is based primarily on whether you've borrowed responsibly in the past, made loan and credit card payments on time. The FICO score can take both personal and business debt into account. FICO score is a very important business finance term, especially, if you plan on applying for a business loan.
Borrowers with the lowest or worst FICO scores have interest rates on average that are 60% higher than borrowers with the best FICO scores.
Personal Guarantee
When borrowing money for your business, you might be asked to sign something called: a personal guarantee. A personal guarantee is a written promise that you make to the lender, backed by your personal assets to pay back a business loan, if the business is unable to pay. A personal guarantee is usually part of your business loan agreement or contract.
Let's say you take out a $50,000 business loan but your business doesn't do as well as you expected and you're unable to make your payments. If you signed a personal guarantee the lender can come after your personal assets such as your home, car, or personal bank accounts to recover the balance. There are a few different types of personal guarantees. Broken down into two major types: unlimited unlimited and an unlimited personal guarantee, the lender can recover 100% of the loan amount from your personal assets.
In a limited personal guarantee the lender is limited to recovering a specific dollar amount from your personal assets.
Limited personal guarantees can be further broken down into “several limited guarantee” and “joint and several.” These are commonly used terms for multiple owner businesses:
Under a several limited guarantee. Each business owner is responsible for a predetermined percentage of the debt, and a creditor can come after each business owner only for their respective portion of the business debt.
In contrast, in a joint and several limited guarantee, a business owner might become liable for the entire debt if other business owners don't pay their fair share. With your personal assets on the line, signing a personal guarantee can be risky, but it's also usually required to receive a business loan.
Collateral
Collateral is closely related to personal guarantees. Like a personal guarantee, collateral provides some security for the lender if your business is unable to pay back a loan. Collateral is an item of value such as a piece of equipment or inventory that you pledge in exchange for a business loan. If your business defaults on the loan, the lender can sell off the item to recover the balance.
Now lenders don't like to go through the seizure and sale process. But it can happen if several months or years have passed since you've made a timely loan payment. Depending on the type of loan you have, you might not have to provide collateral that's equal to the value of the loan. For example, a building that's worth $100,000 might be sufficient collateral for a $150,000 loan.
Some types of loans such as equipment loans are called: self securing loans.
This means that you don't need to provide additional collateral beyond the equipment itself that can be very helpful for new businesses, which often lack a lot of collateral.
Annual Percentage Rate
You’ll hear Annual Percentage Rate or APR when applying for a business loan. Most small business owners want to know one thing: how much will this loan cost me? The annual percentage rate tells you how much you'll pay for a loan over a one year period, including all fees.
That last point is important because a regular interest rate does not include fees. Only APR will tell you the cost of a loan with fees included: application fees, packaging fees, origination fees, documentation fees, and other fees can often increase your loan cost significantly.
Here's an example, if you have a $50,000 5-year loan with an interest rate of 10% and a 2% origination fee, your APR is 10 point at 8% and you have to pay $14,741 in total interest payments to the lender.
In contrast, if that loan has an interest rate of 15% and a 4% origination fee, the APR jumps up to nearly 17%. And you have to pay $23,370 in total interest payments to the lender. That's almost a $10,000 difference in the amount of interest you have to pay to the lender. So make sure you ask the lender for APR when shopping for a business loan.
Now that you understand these terms, you'll be able to gain a competitive edge and better plan for your business's success.