Essential Financial Concepts Every Small Business Owners Should Grasp: A Simplified Guide
To go big, you need to start small. In the business world, to be able to read your financial statements, perform advanced financial analysis, and create other business reports, you need to know the basic, yet essential, financial concepts.
Financial literacy is the backbone of any successful small business. Yet, many small business owners find themselves overwhelmed by the complexities of finance which turns into avoidance.
So to help you avoid the overwhelmed, in this article, we will not only go over the essential financial concepts that you, the CEO, should know for your business, but will also discuss the common misconceptions about each finance concept, its formula, and the importance it will contribute to you during decision-making process.
And let us start with:
Revenue refers to the money your business earns through its operations, such as sales, service fees, or any other revenue streams. As a rule of thumb, do not depend on a single income, consider to have multiple!
Formula: Total Income = Sales Revenue + Other Revenue Sources
Misconception: Small business owners often confuse income with profit. They think that if they have substantial income, they must be making a significant profit. This couldn’t be further from reality as income only takes into account what you make, not what you spend. You can generate $1M in income but be left with $1K in profit, or you could only make $10K in income but be left with $8K in profit.
Why it is important: Knowing your income helps you understand your revenue sources and whether they are sufficient to cover your expenses and generate a profit.
Expenses are the costs your business incurs in its day-to-day operations. The three main buckets of expenses are Cost of Goods Sold/Cost of Sales (i.e., direct labor), Other Operating Expenses (i.e., rent, meals, travel), and Non-Operating Expenses (i.e., interest, taxes, depreciation)
Formula: Total Expenses = Cost of Goods Sold/Cost of Sales + Other Operating Expenses + Non-Operating Expenses
Misconception: Some business owners underestimate their expenses, thinking they’re lower than they actually are, leading to financial strain. Find out here the top five business expenses small business owners typically underestimate.
Why it is important: Accurately tracking expenses helps you manage your cash flow and make informed decisions about cost-cutting or cost-increasing.
Assets are what your business owns, including cash, equipment, inventory, and real estate.
Formula: Total Assets = Current Assets + Non-Current Assets
Misconception: Small business owners may overlook intangible assets like intellectual property or customer lists, which have value. Some of them are confused too on what should be categorized under current and non-current assets.
Why it is important: Understanding your assets helps you assess your business’s value and potential for growth or obtaining financing.
Liabilities are your business’s financial obligations, such as loans, unpaid bills, or accounts payable. Like assets, you also have current and non-current liabilities.
Misconception: Owners sometimes underestimate the long-term impact of their liabilities, leading to cash flow issues. Categorization of current and non-current liabilities is also one of the confusion of small business owners, which can also lead to cash flow issues with a lack of understanding of the timing of repayment based on whether the liability is current or non-current.
Formula: Total Liabilities = Current Liabilities + Non-Current Liabilities
Why it is important: Managing liabilities helps ensure your business can meet its financial commitments without strain. Liabilities are also sometimes needed to help your business grow and scale, so understanding the appropriate levels of liabilities in your business is critical to making sound strategic decisions.
5. Cash vs. Profit:
Cash and profit are not the same! Cash refers to the actual money your business has on hand, while profit is the amount left over after deducting all expenses from income.
Misconception: Small business owners may assume that high profits automatically mean sufficient cash flow, which isn’t always the case. Cash should never be an afterthought, it should be the main thought.
Cash Flow = Cash Received – Cash Payments
Profit = Revenue – Expenses
Why it is important: Distinguishing between cash and profit helps you make decisions about spending, saving, and investing.
6. Cash Burn Rate:
The cash burn rate measures how quickly your business spends its available cash.
Misconception: Some entrepreneurs ignore the cash burn rate, thinking they can keep spending without consequences. Keep a keen eye on how fast you’re burning through cash.
Formula: Cash Burn Rate = (Beginning Cash Balance – Ending Cash Balance) / # of Months
Why it is important: Monitoring your cash burn rate helps you gauge your runway and make needed adjustments to avoid running out of cash.
7. Cash Runway:
Cash runway represents how long your business can operate with existing cash.
Misconception: Owners may assume that having a cash balance means they have a substantial cash runway. Not true, as your cash runway depends on your cash needs on a monthly basis.
Formula: Cash Runway = Cash on Hand / Average Monthly Cash Burn Rate
Why it is important: Knowing your cash runway allows you to plan for the future and take necessary financial precautions.
8. Working Capital:
Working capital is the funds available for your business’s day-to-day operations.
Misconception: Business owners oftentimes do not realize the importance of maintaining adequate cash to ensure you can meet your short-term financial obligations and unexpected expenses.
Formula: Working Capital = Current Assets – Current Liabilities
Why it is important: Sufficient working capital ensures your business can meet short-term financial demands and seize opportunities.
9. Tax Liability:
Tax liability is the amount of taxes your business owes to the government. We recommend having a Tax Professional (one of the financial trifecta) to ensure you comply with the necessary tax requirements.
Misconception: Taxes are something that many small business owners feel that they can delay and put off. This often leads to an underestimated tax liability, further leading to unexpected financial burdens.
Formula: Tax Liability = Tax Rate × Taxable Income
Why it is important: Proper tax planning helps you avoid penalties and ensure compliance with tax regulations.
Depreciation accounts for the reduction in the value of assets over time.
Misconception: Though a non-cash transaction, some entrepreneurs overlook depreciation, thinking it doesn’t affect their financial statements.
Formula: Depreciation Expense = (Asset Cost – Salvage Value) / Useful Life
Why it is important: Understanding depreciation helps you accurately assess your assets’ value and plan for replacements.
As we wrap up these essential financial concepts, I just want to remind you again that, yes, those are just “terms, formulas, and definitions” but understanding them from a CEO’s point of view, can significantly impact the success of your small business.
Lack of financial capacity will cost you money. Use this concise, clear guide to save you time and prevent costly mistakes.
Always remember that the path to success begins with a solid understanding of these essential financial concepts. Embrace them, apply them, and watch your small business reach its financial goals!
“But Marguerite, I am already quite familiar with the financial concepts but my business is stuck! I don’t feel its growth. I only sell, deliver items/services, receive payments, pay expenses, and repeat. What should I do next?”
If you want to know the next steps and specific actions that result in reaching and exceeding your business’s financial goals – take this 2-minute quiz and find out where your business stands! CLICK HERE
BONUS: Download the Essential Financial Concepts Guide now to avoid common misconceptions, master formulas, and make informed decisions for your business.