Finance Terms Every Entrepreneur Should Know
There are some basic financial concepts that every entrepreneur should be familiar with, in order to not be lost in their own finances. Founders may have innovative ideas, a great business plan, remarkably good management skills but they may never actually have an overview of how their business is doing without knowing what lies behind some basic financial concepts.
In this series, first we’ll go into a quick summary of basic elements in finance and work our way up from there.
Part 1 is going to be about basics: balance sheet. What is it? Why should you care? What do you need to know about it as an entrepreneur? Read ahead!
Why do you need a balance sheet?
A balance sheet is used provide a picture of a company’s financial state in a specific point of time. As an entrepreneur, you need to have a balance sheet for several reasons.
1- So you can run your enterprise smoothly
A balance sheet is not a typical statement that shows you how you are spending your money, it is more than that. It shows what your company owns, what your company owes and what its worth is.
2- So you can get some tax back
A balance sheet helps you apply for tax reductions - this is related to “depreciation” , which we we will talk about that in upcoming blogs.
3- So you can get investors
You’ll need a balance sheet the most when it is time to attract investors to your business. Investors would like to know what your business is actually worth. So it is so much better for you to start keeping track from the beginning.
So let’s get started. What’s a Balance Sheet?
A balance sheet is your main way of determining what the company owns and owes. This includes the assets, which are the company’s money and belongings. Then there are the company’s liabilities, which are what it owes to others. Equity is the difference between what the company has and what it owes, so its “net worth.”
Understanding the Balance Sheet
The Balance Sheet has 3 elements to summarize how a company is doing at a specific time. These elements are Assets, Liabilities and Equity.
An asset is something that your company owns that has a value. So an example of an asset is a machine that your company owns. Or land that your company owns. It can also mean the software or the patent that your company owns.
So to differentiate between all these different types of assets, there are four different ways in which they can be described:
Current or Fixed, Tangible or Intangible.
Let’s have a look at these definitions:
A current asset can be converted into cash quickly. Examples are cash (it is a current asset too!), investments and inventory.
A fixed asset is what can not be converted into cash quickly and is for long-term use - for example a building or land.
A tangible asset is anything that can be touched for example, a machine.
An intangible asset does not exist, physically. For example: a patent, or copyrights.
A liability (debt) is what a company owes to others. Your company’s financial obligations can be current or long term. Current liabilities are the liabilities that you will pay within one year, (for example a bill that your supplier sent you).
Long-term liabilities due after than one year or more (for example, a bank loan). Sub-terms: Current (short-term) liabilities (debts), Fixed (long-term) liabilities (debts)
Equity is the owner’s share in the company. It is basically the assets minus the liabilities. What is left is the net worth of the company, or, its market value.
Let’s take an example. you and your partner’s company X has a building and machinery worth $100k. Those are the company’s assets. However, you also have a bank loan on the building worth $60k. That is the company’s liability. In this case, the company’s net worth would be $40k. If you and your partner have equal shares in the company, each shareholder’s equity is $20k.
Sub-terms: Net worth, Market Value, Shares
So let’s put all of this in a simple equation.
Equity = A - L
Now we’re going to swap this formula around a little bit. Don’t worry, it’s very basic maths. Another way of looking at this formula is
A = L + E
Assets = Liabilities + Equity
Why would the formula be presented in this way? It’s because of the idea of balance. It is based on the assumption that any asset the company will buy, you will buy it with a liability (cash, a loan), or by equity (with the help of shareholders - so it belongs to them). This will help you see that if your balance sheet is out of balance - something has gone wrong with your finances!
One of the most useful things about a balance sheet is that it helps you understand how much cash your company has. You see, the company can have lots of assets, but these could be land or machines or cars for example. That’s good, but you cannot buy anything with them (not until you sell them first, but that will take time!). So it is interesting to know how much actual cash the company has vs how much cash it owes. This is called the “Net working” capital. This can be written in a formula like this
Net Working Capital = Current assets - Current liabilities
Here of course we only touch on the very basics of Balance sheets. Below we outline some useful resources that can help you learn more about the subject.
- Understanding Accounting Basics
- How to Create a Projected Balance Sheet for a Startup
- Get Your Basic Balance Sheet Template
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Photo Credit: Philippe Put / Flickr