A 2014 report (Financial Literacy and the Success of Small Businesses: An Observation from a Small Business Development Center) showed that half of the small businesses weren’t reviewing their financial statements. And of that 50%, 86% were experiencing financial difficulties. Why?
Businesses weren’t reviewing their statements … because they didn’t understand the financial jargon.
If you struggle to understand the financial lingo, this list of common financial terms and definitions may help. Use it as a reference while you’re working with your accountant or while going over your books each week.
Accounts payable is also called trade payable. It refers to the total invoices for goods and services a business has received but has yet to pay. They’re usually due for payment within 15 to 45 days. In short, this is money your business owes to other businesses.
Accounts receivable is the amount of money a company has to claim or has invoiced. It is from having sold goods or rendered services to its customers. This is what other businesses or customers owe your business.
Accrued expenses are expenses that a business has incurred but has yet to pay. This is because either the invoices have not yet been received or the payments aren’t yet due.
Examples of accrued expenses include interest on loans and taxes incurred. Salaries your employees earn up to the period of reporting but aren’t due for payment until after the report is prepared are also accrued expenses.
An asset is any item your business owns that is of fiscal value and is expected to benefit the business in the future.
Your balance sheet gives an overview of the financial situation of your company. Unlike an income statement, a balance sheet offers a snapshot of a business’s finances at a specific time.
A balance sheet consists of three segments:
- “Owner’s Equity”
These three segments must balance out in a simple equation. Assets = Liabilities + Owner’s Equity. Hence, the name balance sheet.
(You can learn more about income statements further down in this article.)
Cash and Cash Equivalents
Cash and cash equivalents are assets and items that a business can easily convert into cash. Cash equivalents could include checks, certificates of deposit, and treasury bills. If your business doesn’t have cash equivalents, it would only report its cash-at-hand and in the bank.
Cash flow refers to the reconciliation of cash moving into and out of a business. When a business receives more cash than it sends out, it is cash flow positive. A business is cash flow negative when it spends more than it receives.
Cost of Goods Sold or Cost of Revenue
Cost of goods sold refers to the full cost of the production of the goods a business sells.
The equity stake is the part of a company owned by an entity. It is usually expressed as a percentage. In a true sole proprietorship, the owner of the business owns a 100% equity stake.
A franchise is a license. It grants the franchisee access to the franchisor’s trademark and operation guidelines. The franchisor is the entity that owns the trademark. A franchisor is usually an accomplished and well-known company. It uses licensing agreements to expand without spending the capital (money) required.
Gross profit is the cost of goods sold or cost of revenue subtracted from net sales. This excludes operating expenses that do not directly generate revenue. This includes costs such as accounting, supplies, and advertising. It is the first determinant of how profitable a company is. It indicates the financial viability of the products and services the company offers.
Let’s say your detergent manufacturing business sells $50,000 worth of detergent in a year. The raw materials, transportation, production facility rental, and factory labor cost $30,000. Your gross profit would be $20,000.
Gross Profit Margin
Gross profit margin refers to the ratio of the revenue that you keep as gross profit. It is also called gross margin or gross profit percentage.
The formula to calculate this is (Gross Profit/Net Sales) x 100.
A detergent business whose gross profit is $20,000 with net sales of $50,000 has a gross profit margin of 40%. This means the detergent sold returned 40% on the capital that’s directly associated with the detergent production.
Gross sales include the total of all sales activity during a reported period. It excludes sales deductions such as sales discounts, sales returns, and sales allowances. Gross sales figures track how effective sales efforts are, assuming there were no deductions. When you deduct these items, what you have left is net sales or revenue.
Your income statement is also called a profit and loss statement, earnings statement, or statement of operations. An income statement shows all the money your business makes, its expenses, and its profit. The typical frequency for income statements is both quarterly and annually.
If your business is struggling to make a profit, the income statement is the first place you need to look. It will show you if — and where — there’s room for reducing expenses to improve profitability. It can also show if the only way to improve profitability is to make more money.
A liability refers to anything a business owes. This includes loans, mortgages, and advance payment for goods and services not yet delivered or rendered. Liabilities are reported on balance sheets as short-term (current) and long-term liabilities. Current liabilities are typically debts or obligations that are due within a year. This includes short-term loans, interest, and taxes. Long-term liabilities are due over a longer period.
Net income is gross profit minus every expense incurred during the reported period. You get this by subtracting the cost of goods, services, and operating and non-operating expenses from your net sales or total revenue. Non-operating expenses include interest, depreciation, taxes, and advertising.
It is the overall determinant of how profitable a business is. Here’s an example. If your gross profit is $20,000, and you spent $10,000 on operating and non-operating items, your net income would be $10,000. This means your business made a profit of $10,000 after you deduct all production, service, and operational expenses for that reporting period.
Non-Operating Expenses and Loss
Non-operating expenses are costs incurred due to activities unrelated to a business’s core operation. These activities don’t have tangible effects on operating results. This includes, but is not limited to, interest and insurance.
A non-operating loss is a loss incurred due to activities that don’t relate to business operations. A good example would be a loss incurred as a result of a lawsuit settlement.
Non-Operating Revenue and Income
Non-operating revenue and income is the total profit created by a business from activities that aren’t tied to its core operations. Examples would include proceeds from selling business equipment. It can also include profit made from sales due to foreign exchange.
Notes Payable and Notes Receivable
Notes payable are IOUs. These could be funds borrowed from a bank or an amount owed to a supplier for raw materials delivered. Notes payable are a debt instrument. They are recorded as a current liability on a balance sheet if due within 12 months. If they are due over a longer term, they are considered long-term liability.
Notes receivable is the opposite of notes payable. What one company records as notes payable, another company records as notes receivable. Notes receivable appear as a current asset on a balance sheet when expected within 12 months. Anything more than that is considered a long-term asset.
Operating expenses are the costs tied to a business’s core operations. These costs can be classified into two categories. The first category is the cost of goods sold (or cost of revenue) and selling. The second category is general and administrative expenses (SG&A).
Owner’s equity is the totality of the owner’s investment into the business. This is the portion of assets that belongs to the business owner.
Operating income is the revenue or net sales that’s left after you deduct operating costs. It is also called operating profit or earnings before interest and taxes (EBIT). Its calculation excludes non-operating expenses like interests, taxes, lawsuit settlement expenses, etc.
Operating margin is the ratio of revenue or net sales a business keeps as operating income. It is calculated by dividing operating income by revenue or net sales. The result is then presented as a percentage by multiplying by 100.
For example, a business’s operating income was $10,000 on a $50,000 revenue or net sales. Its operating margin is then $10,000/$50,000 = 0.4 x 100 = 40%.
Operating margin helps determine how efficient a company’s day-to-day operations are. In the example above, the business’s day-to-day operation made $0.40 for each dollar of revenue.
Prepaid expenses are the advance payment for future expenses. Prepaid expenses usually appear on a balance sheet in the current assets subsection. This is because they’re usually due within 12 months. Prepaid expenses usually arise when businesses pay in advance for goods and services needed in the near term.
Insurance is one example of prepaid expense. For example, your business buys an insurance policy of $2,400 over a 12-month period. Your prepaid expenses account will be credited with $2,400 at the beginning of the period. Accountants would divide this by 12 to say you’re paying $200 per month. So, as each month passes, you’d have used $200 out of your prepaid insurance expense. The $200 expensed for a given month will show up in your non-operating expenses column for that month. It will be debited from your prepaid expenses account.
The same accounting process goes for any type of prepaid expense. You can account for rent, supplies, and legal and contract expenses in this way.
Revenue is the total amount of money a company brings in from its business activities after discounts, returned goods, and other sales allowances have been deducted. Businesses that sell goods, such as retailers, are more likely to refer to revenue as net sales. It is also called top-line because it usually appears at the top of an income statement.
Selling, General, and Administrative Expenses (SG&A)
Selling, general, and administrative expenses are expenses you incur while selling your products and services. They also include the cost of running your business on a daily basis. Below is a breakdown:
- Selling expenses include the cost to sell the goods you’ve already produced or purchased. This excludes the cost of production or purchase. It includes expenses related to sales material, traveling, advertising, delivery, warehousing, telephone bills, salaries of sales employees, and sales commission.
- General and Administrative expenses are usually more fixed than selling expenses. They include expenses related to rent, mortgage, insurance, utilities, and salaries of non-production and non-sales employees.
Unearned revenue refers to advance payments a business receives from its customers. It is also called deferred or prepaid revenue. So long as the goods or services for which the payment was made are yet to be delivered, that amount of money remains an unearned revenue. Since it indicates that a business owes its customers, unearned revenue appears as a current liability on balance sheets. Typically, what one entity records as unearned revenue, another entity records as prepaid expenses.
Various businesses incur unearned revenue differently. For example, a subscription service company that bills its customers yearly will have one year’s worth of deferred revenue. As each month passes, a portion of the subscription fee proportional to a month’s service will be deducted to reflect the worth of subscription service left undelivered. Deductions from the deferred revenue account are credited as revenue in the income statement.
Managing your finances is one of the most important parts of running a business. Unfortunately, small business owners who have little financial background shy away from these responsibilities. By learning these key financial terms, you’ll be more able to understand your financial statements, communicate with finance professionals, and monitor your business’s cash flow.