Home Opinion & Blogs Financial Literacy for Entrepreneurs Series – Part 1

Financial Literacy for Entrepreneurs Series – Part 1

Financial Literacy for Entrepreneurs

Not every entrepreneur is a finance person. Some might not even know the F of Finance. In the early days of the startup, the founder mainly focuses on consolidating the business, developing the product and the team. Meanwhile, managing the business accounts is usually done by founding members who might not actually be qualified in finance. Without hiring a finance guy, the founder might find it hard to focus on financial analysis and managing expenses and incomes. 

In order to have control over your business, it is imperative for every entrepreneur to achieve a certain degree of financial literacy. While talking to prospective investors, equity firms or ventures, the ability to talk in the financial lingo can prove invaluable for the future of the business. Apart from financial knowledge, successful money management requires one to understand his/her emotions and personality that influence how they address money matters and make financial decisions. 

In the Financial Literacy for Entrepreneurs Series, we will discuss some of the most important financial terms every entrepreneur must know.

1.     Assets

Assets are anything and everything that a company owns. An asset has a monetary value. Some assets are land, vehicles, inventory, cash, patents, copyrights, furniture, accounts receivable etc. There are four types of assets: 

Fixed assets: Assets with low liquidity, i.e. we cannot convert them into cash quickly. These are purchased for long term use such as land and buildings and are subject to depreciation over time.

Current assets: Assets with high liquidity that can be converted to cash quickly like inventory, cash and investments.

Tangible assets: Assets that you can touch. Example: machines and furniture.

Intangible assets: Assets that you cannot touch. Example, patents and copyrights.

2.     Liabilities

Liabilities are any debt which the business has since it was incorporated. For example, credit card debt, bank loans, money owed to suppliers etc. Liabilities are of two types:

Current liabilities: Debt that is settled within a year, short term liabilities. 

Fixed liabilities: Debt that is settled over more than one year, such as a 10 year bank loan.

3.     Cash Flow

Cash Flow is the net amount of cash and cash equivalents transferred into and out of business. The cash flow of a company is determined by looking at the organisation’s cash balance at the beginning and end of a period.

A positive cash flow means that A company is adding to its cash reserves and reinvesting it in the company, paying out money to shareholders or settling future debt payments, it is called positive cash flow.

The three primary forms of cash flow are operating (cash generated by a company’s main business activities), investing (purchases of capital assets and investments in other business ventures) and financing (proceeds obtained from issuing debt and equity as well as payments made by the company).

4.     Cost of Sales

Cost of Sales is what the raw materials and production process costs. In simple words, it is the total accumulated cost spent on creating a product or service that has been sold. Cost of Sales measures the ability of a company to design, source and manufacture goods at a reasonable cost. There are two main types of costs-

Fixed Cost: The cost of items that do not change no matter how many products are produced. It is the cost of the fixed factors of production.

Variable Costs: It is the cost of the varying factors of production such as Labour, that changes depending on how many products are produced. 

Cost of Sales = beginning inventory + purchases – ending inventory.

5.     Bottom Line

Bottom Line refers to the company’s overall profit, which is the final figure at the end of income statement. Net Earnings and Net Income fall under the Bottom Line. The phrase “affecting the bottom line” of the company means any action that may increase or decrease the company’s net earnings or overall profit.

Increasing the bottom line means reducing expenses. Decreasing wages, operating out of less expensive facilities, increasing production efficiency, utilizing tax benefits etc., grow the company’s bottom line. A decrease in the bottom line indicates that the company has suffered a dip in income or a surge in expenses.

6.     Gross Margin

The gross margin refers to the percentage of the sales earnings that a company keeps after deducting the costs for producing the product or service. This percentage is used to pay for overhead expenses like rent, salaries and others.

Gross margin = Net sales revenue – Cost of goods sold.

Gross Margin is the sales revenue a company retains after incurring the direct costs of production. The higher is the gross margin, the more capital a company retains on each dollar of sales. Example, suppose a company’s recent quarterly gross margin is 25%, it means that the company retains $0.25 from every dollar of revenue generated.

7.     Working Capital

The working capital of a company represents its operating liquidity. It is a measure of the efficiency and the short-term financial health of a company.

Working Capital = Current Assets – Current Liabilities

If current assets are less than current liabilities, we have a working capital deficiency or working capital deficit.

The working capital ratio (current asset/current liabilities) is a good metric to see if a company can pay their short-term debts. A ratio less that 1 is not a good sign and anything above 2 implies that not enough capital investment is happening.  

8.     Leverage

Leverage usually refers to the amount of debt that can be used to finance your business’ assets. It is the amount you borrowed to run your business. Having more debt than equity is considered to be highly leveraged, meaning very risky.

Leverage can also be understood as an investment strategy of using borrowed money to increase an investment’s potential return. Leverage comes in several varieties, including financial, operating and combined leverage.

9.     Capital Expenditure (CAPEX)

Capital expenditures, commonly known as CAPEX, are funds used by the company to purchase items for the business, creating future benefits. It is expenses incurred on acquiring, upgrading and maintaining physical assets like land, machines or technology. It is used to undertake investments or a new project. CAPEX is a vital part of the balance sheet as it tells how much a company is investing in existing and new fixed assets to maintain or grow the business.

CAPEX= Change in property, plant, and equipment + Current Depreciation

10.  Debt vs EquityEquity is a shareholders’ stake in the company, and Debt is the amount of money borrowed by one party from another. An entrepreneur needs to know about the “debt vs equity” comparison. As an entrepreneur, one is always in a dilemma while deciding how much equity or ownership to give away to get investment. If an entrepreneur doesn’t want to give away equity, they turn to banks for loans. Both are an integral part of the business and come with their pros and cons. To learn more about this comparison, check out the article on Debt vs Equity.

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Komal writes about the startup ecosystem on VCBay. She is an Economics Hons. graduate from Miranda House, Delhi University, and is passionate about the world of entrepreneurship and finance.

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