Having a deep understanding of your company’s financial situation can help you divert resources in the right direction, spend more on what generates returns and improve decision making overall.
But for true insight, just knowing your ROI will never be enough.
To really understand your company’s finance, you need to look at the small details. So, what does an entrepreneur need to know about business finance, and how can this knowledge be applied to your own business?
What is Business Finance?
In its most basic sense, business finance is about the raising and managing of funds by business organizations”. Day-to-day basis, this means analysing, planning and controlling transactions. The person in charge of finance will make sure to analyse these trends, and formulate budgets and decisions in response to them.
Deciding how to manage capital is a key decision for any business, and comes with a whole range of factors that will need to be considered. More cash means more stability, but cash sitting in a vault won’t grow your revenue. In fact it will slowly lose value, due to inflation. More debt on the other hand means more risk, but it can help you grow your business.
Finance can be extremely complex, even in relatively small start-up scenarios. When scale is achieved, and equity and investment capital come into play, this complexity continues to multiply.
The first question to assess when trying to understand your business finances you need when starting a business, or when starting to assess your business’ financial situation, is your fixed capital. This refers to any assets your business might have such as land or buildings, equity, machinery, or any type of hardware. Fixed capital also includes the savings, or initial investment, that your company has.
It’s very important to keep track of your fixed capital, to make sure your business has its baseline needs covered. It’s also important because the value of these assets changes over time. Computers and technology lose functionality and lose value as tech evolves and leaves them outdated and machinery is subject to wear and tear. Property and land on the other hand, may increase in value over time. It’s important to keep track of these things in order to understand the value of your business, and of where investments or savings can be made.
Unlike fixed assets, working capital refers to cash flow, and the consumables you need to keep your business running. For a copying center, that might be copier paper and ink. For a shipping company, that might be gas for their delivery cars.
But for all businesses, wages, rent and monthly expenses should be considered whenever considering cash flow. It’s important to have a clear overview of your required working capital, and how your revenue can cover it, to know how much money you have leftover for further investment.
Besides the capital that your business has, and how you keep track of it, you also need to take revenue into account when making decisions. Diversifying revenue sources is crucial to increasing profitability and managing business risk such as market shortages or periods of economic contraction.
As an example, imagine two stores, store A and store B, both selling baby products. Store A only distributes products physically, while store B also has a thriving online shop. When the pandemic hit and the street was locked down, it is likely that store A - which had failed to diversify - will have taken a bigger hit to their revenue than store B.
The same principle applies to all types of income sources, whether off or online, in different market segments, or for different variations to a service. It’s important that your revenue is diversified to grow your business, and overcome economic downturn.
Another important aspect of business finance is budgeting. Your company should have an yearly or quarterly budget, and a more specific, detailed monthly one. With a clear budget that accounts for all expenses and revenues in advance, you can better divert resources to the projects that need it most.
Moreover, budgeting doesn’t end with a spreadsheet drafted at the beginning of the year. Your company should always strive to stick to a budget, but this can also sometimes be an organic document. Unexpected costs do come up, as do profitable time frames.
Based on capital, diversification and budget, you should also be able to forecast future expenses and revenue. While the unexpected means forecasts and reality will always differ to some extent, creating a forecast allows key decisions to be made and prepared for ahead of time.
To forecast business finances, you should:
- Estimate sales and all types of revenue in a given time period. Remember that this is a joint effort of finance, marketing, and product development.
- With an estimate on revenue, you should analyse all costs based on fixed and working capital.
- With these estimates and analysis done, you can analyse the performance of your business against an estimate, and see what went wrong, or what went right.
Business Metrics To Keep Track Of
Another important thing to consider when it comes to business finance is the metrics you will use to budget and forecast.
Here are the some important metrics which can help you grow your business successfully.
- EBIT - Earnings before interest and taxes.
- EVA - Economic value added. It’s a company’s financial performance based on residual wealth. You can calculate it by deducing your cost of capital from your operating profit.
- Berry ratio - comparing your gross profit to your operating expenses. If the ratio is above 1, that means your company is making profit above all variable expenses.
- Net cash flow - This is the difference between the cash coming in, and the cash going out of your business in a given time frame.
- Gross profit margin - You calculate it as your revenue, minus the cost of goods sold, all divided by Revenue again.
Keeping a business’ finances clear is one thing. A spreadsheet and a few afternoons can take care of that.
But for businesses that really want to make the most out of their finances, and use them to make the right business decisions, finance needs a bit more focus. With preparation however, businesses can begin applying business finance best practice to day-to-day activities, which will yield long-term results.