Building a company is a lot more complicated that coming up with a great idea, then finding customers who want to buy it. The business has to be profitable, which requires a lot of financial knowledge and strategy. Here are 10 financial terms all business owners should know as they grow their companies.
1. Gross margin: The difference between your revenue (or sales) and the costs to sell them. Revenue alone isn’t an indication of business success, says Gabrielle Loren, a chartered professional accountant and partner at Loren Nancke & Company in British Columbia. For instance, if a company sells $100,000 in its first year and its costs are $25,000, and then makes $200,000 in its second year but its costs were $70,000, their margin was actually higher in the first year, or 75 per cent versus 65 per cent. “It’s important for businesses to look at it and say, ‘Am I actually making more money?’ They do that by asking, ‘How much profit did I make?’”
2. Fixed versus variable costs: As the names suggest, fixed costs don’t change, while variable costs can, regardless of a company’s sales or output. Fixed costs include rent or building leases, machinery and equipment, and depreciation if these items are owned. Variable costs include wages, utilities and the price of raw materials. Ms. Loren uses the example of a coffee shop, where fixed costs are the rent, and variable costs are the price of the beans and milk, and the salary paid to staff serving the lattes and cappuccinos.
3. Capital expenditures (also known as capex): These are fixed costs that add value to the business, such as computers and machinery, says Alkarim Jivraj, CEO of Espresso Capital, which provides financing for technology startups. “This is an important value to ensure you are properly managing and reporting your expenses,” he says. In accounting terms, these costs need to be capitalized, or spread over the life of the asset. In other words, you don’t deduct them in one year.
4. Operating expenses: These are different from capital expenditures because they are shorter-term costs required to run a business. Unlike capital expenditures, operating expenses can be fully deducted in the same tax year. Examples include insurance costs, legal fees and office supplies.
5. Intangible Assets: These include trademarks, brand names, patents and copyrights. Intangible assests, says Ms. Loren are, “very difficult to accurately describe on a balance sheet due to their nature, therefore the creation or purchase cost is what is reported.” For example, even if a company has a patent worth $1-million, if they only spent $50,000 developing or purchasing the patent, it would only appear on the balance sheet as $50,000.
6. Goodwill: An intangible asset that determines the value of a company’s brand name, customer base and relations. “When a business purchases another company, from an accounting perspective, the physical inventory, plant and equipment are tangible assets,” says Ms. Loren. “However, the worth of the brand name is also included in the purchase price. The intangible value of the brand becomes the ‘goodwill’ asset, and is equivalent to the difference between the purchase price and the value of all tangible assets.”
7. EBITDA: This acronym gets thrown around a lot in financial reporting and stands for earnings before interest, tax, depreciation and amortization. It is an understanding of a company’s profitability, says Mr. Jivraj. “This is an important value for an investor to understand where a company stands in terms of their success.”
8. Return on investment (ROI): ROI measures the amount of return on an investment relative to its cost. “Small-business owners may consider ROI the most important metric when determining whether a certain product or process will yield positive results,” says Jamie Firsten, a partner in the business law group at Cassels Brock. “When businesses can neatly attribute revenue or profit to a particular investment, such as an output increase from a sewing machine to replace hand sewing, then decision making becomes much easier.” Mr. Firsten says the ROI can sometimes be difficult to determine for small-business owners when the returns are not easily attributable to a particular investment. “These issues are more prevalent today, where certain products and processes investments, such as computer software, sometimes lead to incremental cost savings and efficiencies,” he said.
9. Letter of Intent: Also known as LOI, this is an offer to buy or sell a company, or outlines key terms in a customer contract. “Most LOIs are not legally binding, but rather serve as a starting point for terms of a business transaction,” Mr. Firsten says. Its purpose is to settle as many of the business and legal points as possible, to increase likelihood that the deal closes.
10. Debit versus credit: For consumers, a debit card allows us to draw money from our bank accounts, while a credit card is money borrowed from a bank. In accounting it’s different thanks to the so-called “double-entry” bookkeeping system. It all comes down to assets (what the business owns) and liabilities (what it owes), as well as income and expenses. “Putting money in the bank is always a debit. Taking money out is a credit,’ says Ms. Loren. “On the flip side, when you increase your liability it’s a credit and if you decrease it, you’re paying down the money.”
Confused? Thankfully, that’s why we have accountants.
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