This guide has been developed to help those with limited business finance experience improve financial awareness and perhaps, business effectiveness. It will cover several areas of financial management including:
- Language of Money (glossary)
- Financial Statements
- Budgeting
- Financial Projections
- Cash Flow Management
- Business Debt
LANGUAGE OF MONEY
For those not formally trained in accounting, there are terms you will need to know to effectively manage business finances. The more commonly used terms are explained below.
Accounts Payable: Accounts payable represent your business’s obligation to pay debts owed to lenders, suppliers, and creditors. Sometimes referred to as A/P or AP for short, accounts payable can be short or long-term depending upon the type of credit provided to the business by the lender.
Accounts Receivable: Also known as A/R, accounts receivable is the money owed to your small business by others for goods or services rendered. These accounts are labeled as assets because they represent a legal obligation for the customer to pay you cash for their short-term debt.
Accruals: A business finance term and definition referring to expenses that have been incurred but haven’t yet been recorded in the business books. Wages and payroll taxes are common examples.
Asset: Any item of economic value owned by an individual or corporation, especially that which could be converted to cash. Examples are cash, securities, accounts receivable, inventory, office equipment, a house, a car, and other property.
Balance Sheet: A structured listing of an entity’s Assets, Liabilities and Equity (net worth) at a specific time. Assets = Liabilities + Equity.
Break-even Analysis: A calculation of the approximate sales volume required to just cover costs, below which production would be unprofitable and above which it would be profitable. Break-even analysis focuses on the relationship between fixed cost, variable cost and profit.
Budget: A relatively detailed list of costs and revenues projected for a future period of time, typically 1 year. A budget is mostly derived from current-year data plus some portion that is forecast or projected. Budgets provide a means to track financial performance (versus expectations) and to gauge timing for investment in areas such as staffing, capital equipment, supplies and inventory.
Cash Flow: The net balance of cash moving into and out of a business at a specific point in time. Positive cash flow means a company has more money moving into it than out of it. Negative cash flow indicates a company has more money moving out of it than into it.
Cash Conversion Cycle: A working capital metric that shows the average time from the point cash is used to purchase inventory until it’s collected after goods are provided and payment is received.
Cost-of-Goods Sold: This is a total of both variable indirect and direct costs associated with a product or good that is sold. It includes labor cost, material costs, consumable supply expense and more.
Collateral: Assets pledged by a borrower to secure a loan or other credit, and subject to seizure in the event of default. The more common forms of collateral real estate, capital equipment and vehicles.
Current Assets: A balance sheet item which equals the sum of cash and cash equivalents, accounts receivable, inventory, marketable securities, prepaid expenses, and other assets that could be converted to cash in less than one year.
Current Liabilities: A balance sheet item, which equals the sum of all money owed by a company and due within one year.
Days Payable: A measure of the average time a company takes to pay vendors, equal to accounts payable divided by annual credit purchases times 365.
Days Receivable: A measure of the average time a company’s customers take to pay for purchases, equal to accounts receivable divided by annual sales on credit times 365.
Depreciation: A non-cash operating expense that reduces the value of a tangible asset as a result of wear and tear, age, or obsolescence. Depreciation is recorded in the financial statements of an entity as a reduction in the carrying value of the asset in the balance sheet and as an expense in the income statement.
Income Statement: A structured listing showing all income and expenses over a given period, including the cumulative impact of revenue, gain, expense, and loss transactions. (similar to a Profit & Loss Statement).
Intangible Asset: A business asset that is non-physical is considered intangible. These assets can be items like patents, goodwill, and intellectual property.
Liabilities: A financial obligation, debt, or claim, i.e. notes payable and accounts payable.
Lien: A legal claim against an asset which is used to secure a loan, and which must be paid when the property is sold.
P&L (Profit and Loss Statement): Also considered an Income Statement or Statement of Earnings. A structured listing that measures Net Income (or loss) over a defined period using the formula, Revenues – Expenses = Net Income/Loss.
Proforma Statement(s): These are forward-looking financial reports, including income statements, cash flow statements and balance sheets, that are developed using assumptions or hypothetical conditions about events that may have occurred in the past or which may occur in the future. One of the most important uses of pro forma reports is to provide context for decision-making and strategic planning efforts.
Shareholder Equity: If you have chosen to fund your small business with equity financing and you have established shares and shareholders as part of the controlling interests, you are obligated to provide a financial report that shows changes in the equity section of your balance sheet.
Working Capital: The amount of current assets that is left after all current debts are paid. Working capital represents the cash and cash equivalents available to meet short-term obligations, such as unpaid taxes and short-term debt.
To see a full list of financial terminology common to businesses, go to Investopedia’s Dictionary of Business Financial Terms.
FINANCIAL STATEMENTS
There are three primary financial statements that are needed for keeping track of money and profitability. These include Income Statement, Balance Sheet, and Cash Flow Statement. All three are related but differ in time, purpose, and core metrics. In the table below you can see how these three primary business financial statements differ.
Financial Statement Comparison
| Income Statement | Balance Sheet | Cash Flow | |
| Time Frame | selected period | point in time | selected period |
| Purpose | profitability | financial position | cash movements |
| Measures | revenue, expense, profit or loss | assets, liabilities and shareholder equity | cash increase and decrease |
| Beginning Line | revenue | cash balance | revenue |
| Bottom Line | net income | retained earnings | ending cash balance |
INCOME STATEMENT
The Income Statement (P&L) is a report that shows whether a company was profitable over a specific period (usually for one year or some portion of a year). The statement shows revenue and the costs associated with generating that period’s income. The literal “bottom line” of the statement usually shows the company’s net earnings or losses. This tells you how much the company earned or lost over the period covered.
Income statements also report earnings per share or EPS. This calculation tells you how much money shareholders would receive if the company decided to distribute all the net earnings for the period. (Companies almost never distribute all earnings. They usually reinvest them in the business.)
To understand how income statements are set up, think of them as a set of stairs. You start at the top with the total value of sales made during the accounting period. Then you go down one step at a time. At each step, you make a deduction for certain costs or other operating expenses associated with earning the revenue. At the bottom of the stairs, after deducting all of the expenses, you will see how much the company actually earned or lost during the accounting period. This is often referred to as “the bottom line.”
At the top of each income statement is the total amount of money brought in from sales of products or services. This top line is often referred to as gross revenues or sales. It’s called “gross” because expenses have not been deducted from it yet.
The next line is money the company doesn’t expect to collect on certain sales. This could be due, for example, to sales discounts or merchandise returns.
When you subtract the returns and allowances from the gross revenues, you arrive at the company’s net revenues. It’s called “net” because, if you can imagine a net, those revenues are left in the net after the deductions for returns and allowances have come out.
Below the net revenue line are several lines that represent various kinds of cost of sales expenses. Although these lines can be reported in various orders, the next line after net revenues typically shows the costs of the sales. This number tells you the amount of money the company spent to produce the goods or services sold during the accounting period.
The next line subtracts the costs of sales from the net revenues to arrive at a subtotal called “gross profit” or sometimes “gross margin.” It’s considered “gross” because there are certain expenses that haven’t been deducted from it yet.
The next section deals with operating expenses. These are expenses that go toward supporting a company’s operations for a given period – for example, salaries of administrative personnel and costs of researching new products. Marketing expenses are another example. Operating expenses are different from costs of sales (which were deducted above) because operating expenses cannot be linked directly to the production of the products or services being sold.
Depreciation is also deducted from gross profit and takes into account the wear and tear on certain assets such as machinery, tools, and furniture which are used over the long term. Companies spread the cost of these assets over the periods they are used. This process of spreading these costs is called depreciation or amortization. The “charge” for using these assets during the period is a fraction of the original cost of the assets.
After all operating expenses are deducted from gross profit, you arrive at operating profit before interest and income tax expenses. This is often called income from operations.
Companies must account for interest income and interest expense. Interest income is the money companies make from keeping their cash in interest-bearing savings accounts, money market funds and the like. On the other hand, interest expense is the money companies paid in interest for money they borrowed. Some income statements show interest income and interest expense separately while some income statements combine the two numbers. The interest income and expense are then added or subtracted from the operating profits to arrive at operating profit before income tax.
Finally, income tax is deducted, and you arrive at the bottom line: net profit or net losses (net profit is also called net income or net earnings.) This bottom line shows how much the company actually profited or lost during the accounting period.
View a sample income statement.
BALANCE SHEET
A Balance Sheet summarizes your assets and liabilities at the close of business on the last day of a profit period and reports the sources of your owners’ equity. It helps you understand how much money your business has (assets), how much you owe (liabilities), and how much equity owners have in your company.
Assets are things that a company owns that have value. This typically means assets can either be sold or used by the company to make products or provide services that can be sold. Assets include physical property, such as plants, trucks, equipment, and inventory. It also includes things that can’t be touched but nevertheless exist and have value, such as trademarks and patents. Cash itself is an asset as are investments a company makes.
Liabilities are amounts of money that a company owes to others. This can include all kinds of obligations, like money borrowed from a bank to launch a new product, rent for use of a building, money owed to suppliers for materials, payroll a company owes to its employees, environmental cleanup costs, or taxes owed to the government. Liabilities also include obligations to provide goods or services to customers in the future.
Shareholders’ equity is sometimes called capital or net worth. It’s the money that would be left if a company sold all of its assets and paid off all of its liabilities. This leftover money belongs to the shareholders, or the owners of the company.
Balance Sheet Formula: ASSETS = LIABILITIES + SHAREHOLDER EQUITY
A company’s balance sheet is set up like the basic accounting equation shown above. On the left side of the balance sheet, companies list their assets. On the right side, they list their liabilities and shareholders’ equity. Sometimes balance sheets show assets at the top, followed by liabilities, with shareholders’ equity at the bottom.
Assets are generally listed based on how quickly they will be converted into cash. Current assets are things a company expects to convert to cash within one year. A good example is inventory. Most companies expect to sell their inventory for cash within one year. Noncurrent assets are things a company does not expect to convert to cash within one year or that would take longer than one year to sell. Noncurrent assets include fixed assets or long-term assets, which are used to operate the business but that are not available for sale, such as trucks, office furniture and other property.
Liabilities are generally listed based on their due dates. Liabilities are said to be either current or long-term. Current liabilities are obligations a company expects to pay off within the year. Long-term liabilities are obligations due more than one year away.
Shareholders’ equity is the amount owners invested in the company’s stock plus or minus the company’s earnings or losses since inception. Sometimes companies distribute earnings, instead of retaining them. These distributions are called dividends.
A balance sheet shows a snapshot of a company’s assets, liabilities and shareholders’ equity at the end of the reporting period. It does not show the flows into and out of the accounts during the period.
CASH FLOW STATEMENT
The Cash Flow Statement is one of the most important business records for gauging financial health. A cash flow statement shows changes over time rather than absolute dollar amounts at a point in time. It uses and reorders the information from a company’s balance sheet and income statement.
The bottom line of the cash flow statement shows the net increase or decrease in cash for the period. Generally, cash flow statements are divided into three main parts. Each part reviews the cash flow from one of three types of activities: (1) operating activities; (2) investing activities; and (3) financing activities.
Operating Activities
The first part of a cash flow statement analyzes a company’s cash flow from net income or losses. For most companies, this section of the cash flow statement reconciles the net income (as shown on the income statement) to the actual cash the company received from or used in its operating activities. To do this, it adjusts net income for any non-cash items (such as adding back depreciation expenses) and adjusts for any cash that was used or provided by other operating assets and liabilities.
Investing Activities
The second part of a cash flow statement shows the cash flow from all investing activities, which generally include purchases or sales of long-term assets such as property, plant and equipment, as well as investment securities. If a company buys a piece of machinery, the cash flow statement would reflect this activity as a cash outflow from investing activities because it used cash. If the company decided to sell off some investments from an investment portfolio, the proceeds from the sales would show up as a cash inflow from investing activities because it provided cash.
Financing Activities
The third part of a cash flow statement shows the cash flow from all financing activities. Typical sources of financing activities include cash raised by selling stocks and bonds or borrowing from banks. Likewise, paying back a bank loan would show up as a use of cash flow.
While an income statement can’t tell you whether a company made a profit, a cash flow statement can tell you whether the company generated enough revenue to cover expenses. This is particularly important for ventures just getting started or seasonal businesses where most of the company’s annual sales are generated in just a few months.
View a sample cash flow statement.
BUDGETING
Operating budgets are forward-looking documents that help business owners recognize current financial realities and establish near-term spending and revenue plans.
According to leadership expert John C. Maxwell, “A budget is telling your money where to go instead of wondering where it went.”
Once a budget is created, it can then be used to track business financial performance through what are called variance reports. These reports can help identify excess spending, revenue shortfalls and changes in both material and labor costs. They provide a timely “check” on the alignment of original expectations and current reality.
The four major elements of budgeting are:
1. Understanding Your Organization’s Goals: Before you compile your budget, it’s important to have a firm understanding of the goals your organization is working toward for the period covered. These goals should be documented and well communicated to each member of the company’s team. Starting in this way, the budget will align with the organization’s priorities and facilitate help support its’ achievement.
2. Estimating Your Income for the Period Covered by the Budget: Answer this question: “Will my company’s income be appreciably different than the previous year?”
- If you answered NO – An example where you would use last year’s data with minor adjustments would be where customers are locked into multi-year agreements.
- If you answered YES – If new products to be introduced, you’ll need to model sales after your growth plan.
3. Identifying Your Expenses: Once you understand your projected income for the period, you need to estimate your expenses. This process involves three main categories: fixed costs, variable expenses, and one-time expenses.
- Fixed costs are any expenses that remain constant over time, like a long-term lease payment.
- Variable expenses are those that change over time depending on several factors, including production and sales activities. These include supplies, services and staffing-related costs.
- One-time expenses, also called “one-time spends” are those that don’t recur and typically happen infrequently. Purchasing equipment or facilities, developing a new product or service, and hiring a consultant are all examples of one-time expenses.
4. Tracking Budget Surplus or Deficit: After creating a budget, and with business activity going forward, periodically compare actual cost and revenue to the budget plan and calculate gross profit for that period of time. If positive, carry the surplus forward or invest in areas of need. If negative, adjust spending or revise revenue generating tactics.
Revenue from Operations
To create a budget, first estimate and summarize the business revenue expected for the period covered (month, quarter, or year). By starting with revenue, you provide a basis for the next step in the budgeting process, defining expenses associated with the product or service you sell.
If you’re an established business, start with the question “Will my company’s income significantly differ from the previous year?” If customers have multi-year purchase agreements or sales come from stable and mature markets, you can probably use last year’s data with only minor adjustments. But if you expect big changes in revenue, such as with the introduction of new products or entry into new markets, you’ll need to model sales after your business’s growth plan.
Operating Costs/Expenses
When creating an operating expense budget, you will need to recognize and segregate costs that are fixed, variable and non-recurring.
Fixed costs are those expenses that don’t change with sales activity such as rent, insurance, licenses, or real estate taxes.
Non-recurring or “one time” costs are those that pop up now and then like new equipment purchase, an unplanned maintenance event, or attending a conference.
Variable costs are those that do change with time or sales activity like utilities, supplies, shipping expense, product material costs and staffing-related expense. Some examples of variable costs include:
- Cost of goods/inventory (material + labor + activity-based overhead)
- Equipment
- Software
- Rent and utilities
- Phone and communication services
- Marketing and advertising costs
- Office supplies, shipping and postage
- Furniture
- Subscriptions
- Legal fees
- Maintenance and repairs
- Meals
- Transportation expenses
- Insurance
- Indirect staffing
- Employee benefits
- Acts of generosity to your team, customers, and community
Profit/Loss Estimate
With revenue and expense budgets complete, you can now see whether your business will generate a profit or loss in the period you’re projecting. This is why budgets are important as they let owners see whether the plans made are good “as is” or require adjustment to meet financial goals.
It is best to first complete a gross profit calculation which is subtracting cost-of-goods sold from gross revenue. Your gross profit margin should be greater than indirect variable expenses, fixed costs and non-recurring costs that occur during the budget period. If gross profit is negative, you’re in big trouble and will need to explore the basis for the negative result.
Once gross profit is calculated, then net profit is determined by taking the gross profit and subtracting all remaining fixed, variable, and non-recurring expenses from it. The result of this calculation is your net profit. If the result is not in line with expectations, adjustments to your operating plan will need to be made.
Finally, budgets are not only planning tools for achieving financial success, they can also be vigilance tools. By creating budget versus actual variance reports, businesses can see where spending and/or revenue have deviated from original expectations. Then, after investigation, resources can be reallocated, or expenses adjusted to get back on track.
View a sample operating budget.
View a sample budget variance report.
FINANCIAL PROJECTIONS
Financial projections, also known as pro forma financial statements, are an important business planning tool for several reasons. If you’re starting a business, financial projections help you plan your startup budget, assess when you can expect the business to become profitable, and set benchmarks for achieving financial goals. If you’re already in business, you may need pro forma financial statements to quantify the impact of potential business decisions, such as investing in capital equipment, developing new products or just taking out a loan.
Pro forma financial statements include projected balance sheets, income statements, and cash flow statements that lenders and potential investors often require. Pro forma statements can also provide you and your team a consensus outlook to consider before signing on the dotted line.
If there are considerable “unknowns” that may affect your projection, you may want to include a best-case and worst-case scenario to account for all possibilities. Make sure you know the assumptions behind your financial projections and can explain them to others.
Startup business owners often wonder how to create financial projections for a business that doesn’t exist yet. Financial projections are always educated guesses. To make yours as accurate as possible, do your homework and get help. Use the information you unearthed in researching your business plans, such as statistics from industry associations, data from government sources, and financials from similar businesses. An accountant with experience in your industry can be useful in fine-tuning your financial projections. So can business advisors such as SCORE mentors.
Once you complete your pro forma statements, don’t put them away and forget about them. Compare your projections to your actual financial statements on a regular basis to see how well your business is meeting your expectations. If your projections turn out to be too optimistic or too pessimistic, make the necessary adjustments to make them more accurate.
Learn more about pro forma financial statements and samples.
CASH FLOW MANAGEMENT
Cash flow management is the process of planning, tracking, and controlling the movement of cash in and out of a business with the goal of maintaining positive cash flow. It involves forecasting future cash needs and ensuring that there are sufficient funds available to meet these needs, as well as managing any excess cash in a way that maximizes its value. Cash flow management is an important aspect of financial planning and can help a business to stay financially stable and avoid financial challenges, such as bankruptcy or default on loans.
According to a U.S. Bank study, 82% of small businesses fail due to poor cash flow management or a misunderstanding of how it contributes to business continuity. To help avoid this fate:
- Develop timely and accurate financial statements, including cash flow statements.
- Perform monthly cash flow analyses and update forecasts as neededRe-align expenses with business activity monthly
- Optimize the timing of payments to accelerate and cash receipts and take advantage of early payment discounts
Cash flow management is crucial for every enterprise as it supports day-to-day business operations, financial stability and growth, while enabling strategic decision-making. Businesses that maintain a positive cash flow take advantage of new business ventures, thrive in a competitive environment, and successfully navigate financial challenges.
Practices that will help you optimize cash flow in your business include:
- Create cash flow statements and cash flow projections. Update them regularly.
- Invoice customers quickly once your product or service is delivered.
- Establish tracking system to manage outstanding (aged) invoices.
- Provide customers with the latest electronic payment options.
- Transfer/deposit business receipts daily.
- Take advantage of early payment discounts when offered.
- Pay your non-discounted bills when they’re due, not before.
- Establish a line of credit to mitigate extended cash conversion cycles.
- Invest your cash reserve when appropriate.
Learn more about cash flow management techniques at the links provided below.
BUSINESS DEBT
Debt is a necessary part of most business journeys. Businesses use debt to improve cash flow, pay suppliers, run payroll, and more. Taking out loans or seeking financing can be an integral part of a sound business strategy. Debt is a tool that when used judiciously can help launch, sustain and grow a business. But debt that is acquired hastily and not managed properly can cause irreparable harm to any venture.
Proper use and management of debt starts with a clear view of a company’s financial situation. That means you have current financial budgets, profit/loss statements, a detailed balance sheet and cash flow statements. If needed, review [your] financials holistically with your CFO or a financial professional and discuss the company’s capacity to absorb principal and interest payments.
When planned well, debt can provide businesses with a source of growth funding that is more affordable than equity-based solutions. It can also give existing shareholders a means to increase financial returns by leveraging their initial investment without dilution. And debt can provide interest-based income tax savings under current tax law.
If debt has already become an unsustainable burden on your business, consider advice provided in a recent Forbes article by Melissa Houston. She offers five essential strategies that will help you conquer your business debt and take control of your financial future.
1. Identify your debts and prioritize them
To start paying off your business debt, you must first be aware of all your debts. Make a list of all your debts, including credit card debt, bank loans, and any other financial obligations you may have.
Then prioritize them based on their interest rates. High-interest rates debts should be a priority to pay off because they tend to accumulate more interest and become more challenging to pay off over time. Allocate your payments, concentrating on the highest interest-rate debts first.
2. Avoid taking on additional debt
This may seem obvious, but avoiding additional debt while trying to pay off existing ones is essential. Many businesses enter a cycle of borrowing to pay off old debt, which can significantly hinder your ability to pay down debts. Work on paying down your current debt with a consistent repayment plan, and avoid taking on additional debt whenever possible.
3. Renegotiate payments and interest rates
If you need help keeping up with your current repayment terms, contacting your creditors to renegotiate your payment terms or even interest rates is worthwhile. Many creditors are willing to work out a new payment plan with you to help you achieve your repayment goal. By doing so, you can make smaller payments and reduce some of the financial stress of your existing debt.
4. Optimize the profit in your business
The best way to pay off business debt is by optimizing profit within your business. Increasing your company’s net profit margin will give you more funds to pay off outstanding debts. Profit can be achieved by tracking expenses, setting realistic goals, and allocating funds toward debt repayment. Paying off business debt can be feasible with a strategic approach, dedication, and perseverance.
5. Increase your revenue
When you have optimized your business for profit, you have a powerful tool. By increasing your revenue, you can start chipping away at any outstanding debts and move closer to achieving financial stability. Whether investing in marketing campaigns, developing new products, or improving your customer service, generating more sales is critical to achieving your financial goals. With determination and a strategic plan, you’ll be surprised at how quickly you can start paying off those debts and build a stronger foundation for your business.
The bottom line is that paying off business debt can be a challenging task, but it’s not impossible. You’ll be on your way to debt-free business operations by implementing these five essential strategies. Taking control of your debt will set your company up for long-term financial success and stability.
Learn more about managing your business debt by visiting the National Foundation for Credit Counseling website.
