Understanding Business Finance

understanding business finance

Financial literacy is a vital skill for a small business owner. To make financially sound decisions, you should be able to understand the figures and to track and analyse your financial statements. If you do not understand the statements yourself, you will always be at the mercy of another person – definitely not an ideal scenario.

But unless you are an accountant, it can be hard to make sense of the figures and to know when things aren’t looking exactly right. A small start-up business owner often does not have the luxury of a full-time financial manager. Many even lack the necessary funding to have an accountant check over the figures monthly. The thing to do, therefore, is to learn the some basic skills yourself.

Whether you are just starting a business, or you are a business owner who is not financially savvy, these tips can help you get on the right track with your finances.

Set a budget

The budget is an important tool for a small business owner. It helps to estimate the revenue and expenses over a period of time and helps you to allocate your resources according to plan. In order to prepare a budget, start with what you know – your current sales and how much you earn in revenue – and then extrapolate this according to your estimate of what will happen in future. Next, analyse the cost of the actual sales and the other expenses or overheads – like rental charges, marketing expenses etc.

How often you budget – monthly, quarterly, semi-annually or annually – is up to you but generally, the more frequently you budget, the more detailed picture you get. For small businesses in the starting out stage, a monthly budget is often the best choice for staying on track and making sure your expenses are not exceeding budget.

Do monthly reviews through profit and loss statements

Preparing monthly profit and loss statements help you review how your business has performed that month. It is a simple statement which adds up your income over the period and subtracts your expenses in order to calculate the net profit or loss during that time period.

Though a monthly statement is not mandatory, it will help you to record how much money you are making and to track your business’ financial health and growth over time. You can also identify potential problems sooner and help correct them. This statement can also act as a proof of income if you wish to apply for a loan and can make it easier to calculate the income and expenses for tax purposes.

Keep track of the cash flow

While the profit and loss statement is an effective tool, it acts on an accrual basis – it takes into account the credit and debit situation also. Even if you can show a net profit on paper, if you do not have enough cash on hand for day-to-day functioning, your business cannot be in a healthy situation. This is why it is so important to keep track of the actual cash flow – the actual amount you have on hand. Don’t forget the balance sheet The balance sheet, otherwise called the ‘statement of financial position’ is another document that shows a snapshot of the financial health of your business at a particular time. It shows the exact value of your assets and liabilities at that moment.

Though it sounds similar to the profit and loss statement, there is a difference – the balance sheet is cumulative while the profit and loss statement returns to zero at the end of each time period.

As a lay person, the balance sheet is more difficult to understand than the other documents since it includes both fixed and current assets and current and long-term liabilities. To get the correct picture, intangible assets like any licenses, works actually in progress and long-term adjustments for non-paying customers have to be monetised and taken into account.

Compare your performance against profit projections

For a successful business, your performance should exceed, or at least keep up with the profit projections you have made. Regular profit and loss statements allow you to compare your actual performance with the projections. Take into account both gross and net profit margins and use them as benchmarks to get an idea of where you stand.

Internal benchmarking involves comparing your profit margins against previous periods of time. If you have multiple products or services, you could also compare them and see which is more profitable. External benchmarking is where you compare your margins against those of competing businesses in order to understand your position in the industry and to set improvement goals. Profit margins allow you to figure out the sales level required for breaking even and how much you can manoeuvre pricing.

Do your own accounting

When starting out, it isn’t such a bad thing to do your own accounting as it keeps you more aware of your financial situation and helps you tackle problems as and when they arise. Once you understand the fundamentals, basic accounting does not need superior math skills – anyone can master it. Online accounting software (for eg. Xero or MYOB) are also available which make it relatively simple to perform the necessary tasks.

As your business grows, you will find it necessary to use the services of a bookkeeper or accountant. Even then, for a successful business, it is important to understand and keep track of both the current and long-term financial picture yourself. Just because someone else is now taking care of the day to day financials you still need to be very much on top of the accounts on a monthly or weekly basis.

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