How important do you think it is for entrepreneurs to understand the fundamentals of the financial tools that enable their businesses to operate successfully? It doesn’t matter if someone is from a medical background or an engineering background. We all deal with money every day. Knowing basic finance terms helps entrepreneurs formulating their strategies, balancing their long-term investments, or simply keeping a tab about the sales generated.
Continuing our Financial Literacy for Entrepreneurs Series, here are 10 essential finance terminologies every entrepreneur should know:
The professional opinion of the market value of any property such as real estate, a business or antiques, is called an Appraisal. The appraiser must be authorized by a regulatory body governing his jurisdiction. Appraisals are usually done for insurance and taxation purposes and for determining the selling price of a property.
When you are closing a loan for your business, you will need the appraisals for real estate, equipment or business value. Appraisals can help resolve conflicts between business partners by establishing the value of the property to be divided.
- Credit Limit
A credit limit is a ceiling on the amount of the loan used at a given point of time. A line of credit offered to businesses usually comes with a credit limit. The credit limit affects credit scores of individuals and affects their ability to obtain credit in the future. A business line of credit is useful from seasonal or erratic businesses. A lender would give high-risk borrowers lower credit limits. The low-risk debtors usually get higher credit limits.
- Business Credit Score
Just as Personal Credit Scores rank creditworthiness of individuals, Business Credit Scores do the same for businesses. Business credit scores range from 0 to 100. Business Credit Reporting agencies produce business credit scores for companies.
A few factors that are considered while calculating business credit scores are Payment history, debt and debt usage, company size, age of credit history and industry risk. There is no specific weightage attached to each factor. It depends from business to business. But the element that is extremely important to assess the credit score is the payment history. Sometimes the credit scores are almost exclusively calculated based on payment history.
- Debt Consolidation
Debt consolidation is taking out a new loan to pay off other liabilities and consumer debts. Multiple debts are combined to form a single, larger debt. This loan usually has more favourable payoff terms, which could be a lower interest rate or lower monthly payment.
A small business with loans with various payments might want to consider a business debt consolidation loan. It can be used as a tool to help improve cash flow.
Lien is a creditor’s legal claim against the collateral pledged as security for a loan. A lien serves to guarantee an underlying obligation, such as the repayment of a loan. In case the underlying debt is not satisfied, the creditor has the power to seize the asset that is the lien’s subject.
There are various types of liens and lien holders. Some of the most common liens are Bank Lien, Real Estate Lien, Tax Lien and Judgement Lien.
- Invoice Factoring
Invoice factoring is done to turn unpaid invoices into fast cash. It is a great tool to finance short-term needs for small businesses. Invoice factoring is not a loan. It is selling the invoices at a discount to a factoring company in exchange for a lump sum amount of cash. The factoring company that owns invoices collects the money from your customers, typically in 30 to 90 days.
Invoice factoring is a good financing option for business owners whose customers are other businesses. As such customers don’t pay for the goods or services immediately, invoice factoring will provide immediate cash to keep paying employees and for other expenses.
- Retained Earnings
Retained Earnings are the net income or any profits earned that are retained in the business after dividends have been paid to the shareholders. This is also referred to as bootstrapping.
Positive profits allow the management to utilize the surplus money earned.
Many a time, the profits are reinvested back into the company for growth or a new project. An alternative definition of Retained Earnings could be the money not paid to shareholders.
Loans made through nonprofit or community-based organizations that are usually minimal amounts are Microloans. It helps an individual become self-employed or grow a small business.
Microloans are suitable for low-income individuals, especially from less developed countries. Microloan is also known as ‘Microlending’ or ‘Microcredit’. Microloans can vary from as low as US$ 10 to US$ 100 and hardly exceed $2,000.
- Break-Even Point
The Breakeven Point is the point at which the business’ total revenue equals the total costs.
Business Breakeven = Fixed Costs/Gross Profit Margins
Suppose a company has US$ 2M in fixed costs and a gross margin of 40%. Its breakeven point is US$ 5M (US$ 2M / 0.40). It means that the company must generate US$ 5M in revenue to cover its fixed and variable costs. Higher revenue means the company will have a profit and vice-versa.
- Return on Investments (ROI)
Return on Investment (ROI) measures the performance or efficiency of the investment(s) made by the business. ROI measures the amount of return on a particular investment, relative to the investment’s cost. It is a beneficial and versatile metric that can measure the returns on any project, marketing decisions or ad expenditure. While making investment decisions, investors look for positive and high ROI.
ROI = Current Value of Investment−Cost of Investment/Cost of Investment
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Read Part 1 here