10 concepts every small business owner needs to understand
Even if you have outsourced your financial functions, as a small business owner, it is crucial to have a solid understanding of key financial concepts to work with your advisor and ‘speak their language”. This article outlines several important concepts that every small business owner should be familiar with.
- Basics of income and expenses
As a small business owner, it’s important for you to understand how you generate and spend money. This way, you can maintain fiscal responsibility while also promoting business growth.
- Income statements (P&L) versus cash flow
To make smart short-term financial decisions, business owners should always stay on top of the latest cash flow analyses and projections. Remember, a P&L doesn’t tell you if you can pay your bills or how liquid your business is. Keep that in mind!
- Operating cash flow
Understanding a company’s operating cash flow is vital for assessing its performance and cash runway.
- Gross sales versus net profits
As a small business owner, it’s important to pay attention to both sales and expenses to ensure a healthy and well-managed business. Remember, gross sales don’t equal net profits. It’s crucial to understand every expense, know the industry averages, and have enough cash on hand to thrive long term.
- Reading a balance sheet
As an owner, it’s important to understand the line items on a balance sheet. Taking a deep dive into these details can provide valuable insights into your financial well-being. Soon you will instinctively know if something doesn’t look right.
- Unit economics
For small business owners, it’s crucial to have a clear understanding of the expenses and revenues linked to a specific product or business unit. You need to be able to dive into the nitty-gritty of your finances, and that’s where unit economics comes in. The basic idea is simple: you should know the ins and outs of your expenses and revenues for a particular product or business unit. By grasping your unit economics, you’ll have a better grasp of your business as a whole, and it will also help you gain credibility with partners or investors.
- Return on equity
This concept helps us decide whether we should keep investing in the business or look into other investment options. You see, there are always opportunity costs to consider for every investment.
- Cost of goods sold
It’s really important to have a clear understanding of the cost involved in producing your products or services. If you’re not sure how much it actually costs to make your product or provide your services, it’s hard to know how much you’ll have left to cover your overhead expenses..
- Accounts payable and accounts receivable
Effectively managing cash flow through digital tools for accounts payable (AP) and accounts receivable (AR) is crucial. After all, cash is king for small businesses!
- Working capital
Monitoring working capital is important for ensuring the business has enough funds to operate smoothly. If you can’t get enough working capital because of seasonality or other external factors, then you can get loans. A working capital ratio between 1.2 and 2 signifies a healthy business to lending companies. The working capital ratio shows the ratio of assets to liabilities, i.e. how many times a company can pay off its current liabilities with its current assets. The working capital ratio calculation is: Working Capital Ratio = Current Assets / Current Liabilities
Having a solid understanding of these key financial concepts enables you to make informed decisions, effectively manage your finances, and strategically drive the growth and long-term success of your businesses.