Accounting can be intimidating, and it’s not something that comes naturally to all business owners. This is why most decide to delegate or outsource this function. However, you can’t be totally in the dark when it comes to financial terms. You want to be able to understand what your accountant is saying to you. You also want to be informed if you ever seek financing or are trying to attract partners. Here are some accounting terms all business owners should understand.
People often mistake profits with profitability. Gross profits are what you’re actually left with when all your operational and material expenses have been covered. Your profit margin, on the other hand, is expressed as a ratio. If you want to know your profit margin ratio, all you have to do is divide your gross profit by your revenue. For instance, if you run a bike shop and sell a bike for $500 and the bike cost you $300, your gross profit is $200. Divide this by $500 and you get 0.4. That is your ratio. If you want to make this into a percentage, all you need to do is multiply it by 100. In this case that gives you 40%. This means that you keep 40 cents for every dollar you make in revenue. Anything over 25% is considered good.
Cash flow, as its name entails, is a snapshot of the amount and timing of money that flows in and out of a business. It’s a calculation of the cash that is collected and how much is spent on operations. Understanding cash flow is very important when it comes time to make important purchases. It will also influence whether you’re going to purchase or lease. If cash flow is limited, you may want to lease even if you’ll end up paying more in the long run. Also, know that even the most profitable business will have issues if they can’t pay for ongoing expenses. As a matter of fact, it is the top reason why so many businesses go under.
Cash flow forecasting is also very important. This will give you a prediction of the money that will be going in and out and compare it to projected income and expenses. This will allow you to time investments or expansion plans better.
Marginal costs are another thing you will need to pay special attention to. This is the difference in profitability when making more units. You can get this number by dividing the total cost of production by the number of units. Some people may assume that producing more will allow them to be more profitable, but that’s not always the case. Producing and selling more also means that you may need to hire more people, spend more on shipping and logistics, invest in better equipment, etc. This is a very important tool to use if you’re suddenly hit with a massive order and want to know if it makes sense for you.
These are all terms and principles you’ll need to master as a business owner right now. Knowing them can make a world of difference in how you run your business, allowing you to make much better decisions.