Creating a business from the ground up is a challenging task. Business owners, and especially startup founders, are faced with new challenges everyday. Some of which they did not see coming.
It is important to learn and read as much as possible to be prepared for when the unexpected happens. One way you can ‘ready’ yourself is by understanding the most common business and financial terms. Knowing these terms will help any business owner navigate the financial aspect of their company.
Here are 15 financial terms that are essential for every business owner to understand:
This term is key to any business owner’s vocabulary. Asset refers to anything that has value, whether it be tangible or intangible. An asset is usually owned by the business and adds value to the business. Typical assets can include stock, cash on hand, buildings or property owned by the business, or equipment. The rule of thumb when categorising an asset is to think of it as: anything that can be turned into cash value (can be sold).
Liquidity means how quickly an asset can be converted into cash for full market value. This is especially important for when a business is about to go bankrupt or if an investor is looking at the worth of a business.
3. Cash Flow
Cash flow indicates the amount of operating cash that goes into the business. It affects the business liquidity. Cash flow reports need to be done for a certain period of time, decided by the business owner. The time period can be one month, six months, or even a year. It is critical to maintain cash flow as it ensures good financial practices and that the business stays afloat.
Liability can be understood as the obligation that a business has to repay short or long-term debt. Short-term can be seen as less than a year, and long-term debts are normally seen as more than a year period. These liabilities should be stipulated on balance sheets, and financial commitments such as accounts payable, wages, taxes, debt, and accrued expenses are all considered liabilities.
Collateral is an asset that the business uses for security when taking out a loan. It can be anything that has a high value market. When the business fails to meet the repayment of the loan, the lender has the right to take ownership of the asset that the business ‘put down’ as collateral.
The loan-to-value comparison is used when businesses take out a loan to acquire an asset. It is used to see if the asset will be able to cover the total cost of the loan should the business fail to pay the loan back. This is different from collateral, as the loan will cover the cost of the asset. Similar to when a mortgage is taken out. When the borrower fails to pay back the mortgage, the bank repossesses the house, which is then sold to cover the loan that was taken out.
This term links with collateral. It is the legal claim that the lender has on the business’ assets when the business fails to pay back the loan that was made.
8. Personal Guarantee
Usually new business owners need business loans to finance the start of their business. This means that they don’t usually have assets yet to offer as collateral. The business owner signs a statement of personal guarantee which makes them personally liable if the business is unable to pay its dues.
9. Debt Consolidation
Sometimes small businesses have several loans and have to make multiple payments. This is more expensive as each loan has an interest rate added to it. Debt consolidation allows the business to merge these loans into one large amount and only one repayment a month is necessary. This helps to improve cash flow and is a more predictable way to repay loans.
10. Debt-Service Coverage Ratio
Better known as DSCR, is the ratio of cash that a business has available to cover the costs of its debt. Debt is a reality that most small businesses face and includes making principal debt and interest payments. A good indicator is if the business has a DSCR of above one, then the business has enough income to meet all of their debt requirements.
There are two different types of capital, fixed capital and working capital. The two are often confused. Fixed capital indicates the overall wealth of a business, including the current assets, cash available, and investments and working capital refers to the financial resources needed for maintaining the business on a daily basis. These include cash on hand or assets that can sell quickly for cash.
12. Gross Profit
The gross profit of a business is calculated by the total sales minus the cost of goods sold. This is considered as the gross profit and does not show the actual profit of the business. From gross profit, other expenses are then deducted to see actual profit.
13. Credit Limit
Credit limit indicates the maximum amount that a lender will lend to a business. A certain amount is allowed based on the business’ credit score. When the business has used up all of the credit that was advanced to them by the lender, it is then considered as “maxed out credit”. This usually means that the business would not be able to take on more credit.
14. FICO Score
The Fair Isaac Corporation (FICO) score is a type of credit score risk model that calculates the risk that a business has. This risk model determines if businesses are reliable in paying back their dues on time. The model also looks to see if they have a lot of debt already. Essentially, it is used by lenders to see if they can trust you to pay back the loan.
15. Business Credit Report
The credit report of a business, similar to that of a personal credit report, is used by credit bureaus to indicate if you are trusted with paying back credit made. There are multiple things that they take into consideration, like how large the business is, when it was established, previous credit and debt made by the business, how it manages credit, and any legal filing against them (especially bankruptcy).
Knowing these terms will greatly improve the knowledge that a business owner has when it comes to finances. It also alleviates any surprises for the business owner, because understanding these terms also allows them to do more research and prevent bankruptcy.