7 Small Business Finance Concepts that Every Small Business Owner Simply Must Understand
Feb 11, 2020 by Roger Scherping
You don’t want to be an accountant, and you don’t have to be one to run your own small business. You’ve got a bookkeeper to take care of your accounting, and you have a CPA to do your taxes. But in order to talk intelligently to your banker, your managers, or other small business owners, there are a few finance terms that you simply must understand.
Don’t worry; these concepts are easy to understand when they are explained simply. In fact, you probably already understand them just from your experience with your business. This article will formalize what you probably already know intuitively.
Sales
Also called Revenue, Billings, Gross Income, or The Top Line. Whatever you call it, this is the total amount that you charge your customers for the goods and services that you provide them. This is a number that owners pay a lot attention to, and there’s good reason for that because that’s the number used to measure whether a company is growing.
The problem is that often people think that if you are selling more, then you are automatically making more money. Be aware that there is no direct correlation between growth in Sales (The Top Line) and an increase in Profit (The Bottom Line)! We’ll explain about The Bottom Line below, but just remember that more Sales doesn’t necessarily mean that you’re automatically making more money.
Margin
Also called Gross Margin or Gross Profit. This means, how much do you make on your Sales after you subtract all of the costs that you incurred in making those Sales? These costs might include production labor, materials, and outside vendor costs. In other words, you are incurring these costs specifically to fulfill these customer orders.
Gross Margin is often expressed as a percentage of Sales. That means, Gross Margin dollars divided by Sales dollars. Your Gross Margin percentage might be around 17% if you’re in the real estate business, 11-16% in the medical industry, 3% in the furniture business, or 2% in the grocery business. It’s important to know what your Gross Margin percentage is so that you can compare it to your industry to see if you are earning an adequate Gross Margin on your Sales.
Overhead
Also called Sales, General and Administrative Expenses (or SG&A), Fixed Expenses, or Administrative Costs. These are the costs you pay every month just to keep the business going, including rent, office salaries, telephone, office supplies, etc. These costs don’t relate to customer orders. Overhead Expenses also don’t vary much by month; that’s why they’re often called Fixed Costs.
But Overhead represents costs that you need to pay every month – regardless of whether or not you sell anything to your customers! The trick is to earn enough Gross Margin every month to cover your monthly Overhead Expenses. Think of your Overhead Expenses as the cost of doing business, costs that you can try to control but which you can’t avoid.
Profit
Also called Net Income (or Loss), Net Profit (or Loss), or The Bottom Line. Deducting your Overhead from your Gross Margin gives you your Profit (or Loss). Did you sell enough to generate enough Gross Margin to cover your monthly Overhead Expenses? If so, you earned a Profit. If not, you suffered a Loss.
Profit is simply how much money that you made (or lost) during the month. Profit is good because it means that you are being successful financially. You are selling your goods and services at an adequate price to cover your Overhead Expenses and leave some money on The Bottom Line. That money can be used to grow the business, hire more people, or pay yourself a bonus.
Here’s an important lesson to remember: The Bottom Line is far more important than The Top Line! Would you like it better if your Sales went up, or if your Profit went up? Of course you’d want your Profit to go up! Keep that in mind, and always keep a closer eye on The Bottom Line than on The Top Line.
Sales growth is usually good, but sometimes companies find themselves working harder and harder to sell more and more. They don’t realize that all of their extra effort is not returning them more Profit. In other words, they are working harder for less return, and that’s not good. That’s why you need to focus primarily on The Bottom Line!
Cash Flow
Cash is the lifeblood of your business. Your customers pay you, and you in turn pay your employees and your vendors (the companies that provide you with their goods and services). The cash passes through your business like blood does through your body.
For a successful business, cash flows smoothly. The cash comes in, payroll is paid, and checks are cut to the vendors. There is no shortfall because the company has positive Cash Flow, meaning that cash is flowing in faster than it is flowing out.
At an unsuccessful company, though, there isn’t enough cash coming in to pay the employees and the vendors. Cash is actually flowing out faster than it is flowing in. Maybe a payroll gets paid late. Or vendors aren’t getting paid, so they stop delivering goods and services. A period of extended negative Cash Flow is a problem that will require immediate action to increase Sales, raise prices, cut Overhead, or borrow money in order to get the Cash Flow positive again.
Accounts Receivable and Accounts Payable
Accounts Receivable, or AR, is the amount of money that your customers owe you. It is the total of unpaid invoices that your customers owe you but which they haven’t paid you yet. Successful companies keep a close eye on their outstanding AR and make sure that their customers pay them on time. The older an unpaid invoice gets, the harder it is to collect, and it may eventually become worthless, which means your company will never collect the money it is owed.
Conversely, Accounts Payable, or AP, is the amount of money that you owe your vendors. It is the total of unpaid invoices that you owe your vendors but which you haven’t paid yet. Successful companies pay their vendors on time and develop a good credit history. If not, the vendors will stop delivering goods and services, which will negatively impact your ability to serve your customers.
Revenue per Employee
This one you might never have thought about, but it is an important one as your business grows or contracts. For this one, take your Sales dollars and divide it by your number of employees. The result is your Revenue per Employee. The number itself isn’t significant unless you monitor it over time. If your Sales are growing faster than your employee count, then your Revenue per Employee will increase. If you are adding employees faster than your Sales are growing, then your Revenue per Employee will decrease.
As a successful company grows, its Sales will increase faster than its employee count. This means that additional Sales are being generated faster than the increase in the number of employees. As a result, The Bottom Line will typically increase.
What happens when employee count increases faster than Sales? This means that Sales are being generated more slowly than the increase in the number of employees. As a result, The Bottom Line will typically decrease. This is why struggling companies are forced to reduce their employee count -- to keep their Revenue per Employee from decreasing.
Keep a close eye on your Revenue per Employee as your Sales increase or decrease to ensure that your Bottom Line does not suffer!
I hope these simple financial concepts make sense and help you better understand the numbers of yoru business. If not, email me.