4 Basic Financial Concepts Every Entrepreneur Should Know
Okay, let’s get this out of the way. I am not an accountant, neither am I a financial expert. I am just a guy by virtue of the industry I work, had to learn these concepts and many more. Before I proceed, please note that if you really want to succeed as an entrepreneur, there are some basic financial concepts, you must not only know but must begin to look at your business through these concepts.
Business at the end of the day comes down to numbers. How much you made, how much you spend making the money, and how efficient is the use of your capital. Take for instance two competing businesses; let call them Company A and Company B. Company A made 10 million in total revenue last year and the profit before tax (PBT) is 2 million. Company B made 8 million in revenue but made the same 2 million in PBT. Remember these are companies who sell the same product. Both made profit, Company A sold more than Company B but spent more in making that revenue than Company B. We can say, on the face value, that Company B is more efficient in deploying its capital than Company A.
As an entrepreneur, you may be making more, but how efficient are you. Are you maximising the use of your capital? Are you watching your overheads? Are you making sure that there are no leakages you can stop? The below concepts are fundamental. Take your time to learn them and also apply them to your business.
1. Balance Sheet- is one of the financial statements or reports that captures the assets, liabilities and owners equity of any enterprise within a period of time. It summarizes what a company owns, what it owes and the value of the owners’ investments in the business. The formula for a balance sheet is A (asset) = L (Liabilities) + E (Equity), You asset includes cash, inventory, plants and machinery (equipment), monies owed the company by customers and clients (account receivables), anything the company can lay claim on that it is is is called an asset. Liabilities are what the company owes. This includes loans from banks, credit from suppliers (account payables), tax liabilities and so on. Simply put, liabilities are any financial obligations of a company to other entities. Lastly is the owner’s equity. It represents the owners’ investment in a company. It is also the claim the owners have on the company after all liabilities have been settled.
2. Income Statement- is a financial report that indicates a company’s financial performance within a period of time. It is also called the profit and loss statement. It captures the revenue and expenses and net profit from operating and non-operating activities of a company over a given period in time. The statement is usually divided into two parts; operating and non-operating parts. The operating part shows the revenue and expenses associated with the company’s regular activities, while the non-operating section records both income and expenses from activities that are not directly related to the company’s normal activities. As an entrepreneur, what you should look at is how to keep increasing your revenue while reducing your expenses. Doing this will increase your net profit.
3. Cashflow Statement- is a report that summarizes the movement of cash in and out of a business over a given period of time. It is a statement that indicates cash management in a business. Basically, cash coming in from customers or clients, buying your products or services, forms cash inflow into your business. Monies going out of the business, in the form of expenses like salaries, purchase of raw materials, etc., make up the cash outflow in your business. I want to emphasize that Cash is cash. Account receivable (monies owed to the company) is not cash. To keep a healthy cash flow as a business, you must ensure you collect monies due to the business at the earliest possible time and delay payment for as ethically as long as possible.
4. Business valuation- is a way to determine the economic value of a business. It is done for a number of reasons, including when seeking new investors. The question that usually comes to mind when seeking new investment, especially, through equity is how much to sell for what percent of the company. It is important that you have a basic understanding of this concept and apply the same when talking to investors. According to the ACCA, there are three approaches to a business valuation; asset-based (business is estimated based on the value of its net assets), income-based (relies on the relationship between the share price of quoted companies in the same industry and the earnings of the company being valued) and cash flow-based ( determines the market value of a company by measuring the present value of future dividends).
An entrepreneur must understand that everything in business can be measure and a good understanding of financial concepts and how to apply them to make decisions will go a long way in making the business more sustainable. While there are many more concepts to understand, a basic understanding of the above is required to both know the financial status of the business and how efficiently the business is in deploying its capital.