10 Financial Concepts for Business Success

Not everyone who starts a company is a business whiz with an MBA. Even if you’re not a numbers person,financial literacy is necessary to understand how your business is performing. You’ll also need a firm grasp of these concepts if you want to seek investments, borrow money, or expand.

A crucial first step on this path is learning about financial concepts relevant to your work. Learn more about these terms and how they can help you manage your business and reach your financial goals.

What are financial concepts?

Financial concepts are ideas that help us understand money and how it’s used, especially in the context of owning and managing a business. These concepts range from the basic, such as revenue, to the more arcane, such as margins and ratios, used to measure a business’s operational efficiency. The term also applies to concepts widely used in the financial industry and economics. These include interest rates, inflation, stocks, bonds, assets, and many more.

10 financial concepts for entrepreneurs and small businesses

1. Revenue
2. Expenses
3. Profit and net income
4. EBIT and EBITDA
5. Cash flow
6. Capital
7. Balance sheet, and income and cash flow statements
8. Margins and ratios
9. Returns
10. Growth

The journey to financial well-being begins with having a strong knowledge base. Here are 10 financial terms particularly relevant to small businesses:

1. Revenue

Revenue is the money coming into a business, mainly from selling products and services. It may also include income from sources not related to the business’s operations, such as interest and dividends from securities investments, or rent from property the business owns.

Companies typically list revenue from sales of products and services at the top of their financial reports, which is why revenue is often referred to as the top line. Non-operating income sources usually are reported lower in a company’s financial statements.

2. Expenses

A business’s expenses, or costs, are the opposite of revenue: they represent money going out.

Expenses fall into three broad categories:

Production costs

This includes the cost of goods sold (COGS), which is the cost of labor and materials directly used in production. COGS typically vary depending on output volume. Services and intermediary businesses sometimes use equivalent measures, such as cost of sales or cost of order fulfillment.

Operational costs

Selling, general, and administrative (SG&A) expenses such as office rent, utilities, administrative staff salaries, and marketing are the costs of keeping the business up and running. Businesses incur these expenses, sometimes also known as overhead costs, regardless of changes in output.

Non-operating expenses

These expenses fall into two categories: recurring, such as debt interest payments and taxes; and nonrecurring, or unusual, which might include legal settlements, a writedown in the value of an asset such as inventory, or one-time costs for restructuring the business.

3. Profit and net income

A business’s profit is the difference between income and expenses. Ideally, income should exceed expenses. When it doesn’t, a business needs to boost income and cut expenses or it risks failure.

You can measure profit in a few different ways, including:

Gross profit

This is income (sales) minus the cost of goods sold. SG&A costs are excluded from this calculation. The simple formula is:

Sales - COGS = Gross profit

For non-manufacturing businesses, gross profit is:

Sales - Cost of sales = Gross profit

Operating profit

Also called operating income, operating profit accounts for SG&A expenses, or the ongoing costs of running the business.

The formula is:

Gross profit - SG&A expenses = Operating profit

Net income

Also called net profit or earnings, this item appears on a business’s financial statement below operating profit. It’s calculated by subtracting any non-operating expenses, including interest and taxes:

Operating profit - Non-operating expenses = Net income

Net income is often referred to as the bottom line because it’s the final entry on a financial report. Companies often use net income to decide whether to pay out some of their earnings as dividends and distributions to shareholders and owners.

4. EBIT and EBITDA

Business managers and investment professionals sometimes use other profit measures to assess performance, setting aside certain expenses included in net income.

The two main variations, known by their acronyms, are:

EBIT

This is shorthand for earnings before interest and taxes, which is roughly equivalent to operating profit. Excluding interest expenses and taxes allows profitability comparisons among companies, regardless of how they are financed (with debt or debt-free) or their tax rates, which can vary based on location.

EBITDA

Similar to EBIT, this stands for earnings before interest, taxes, depreciation, and amortization. The last two are non-cash expenses accounting for the declining value of a company’s assets—depreciation for tangible assets like equipment and amortization for intangible assets like patents.

These expenses can be substantial for companies invested heavily in tangible assets such as factories and equipment, or companies with assets such as trademarks and patents. Stripping them out can make it easier to compare different types of companies in different industries.

Although EBIT and EBITDA are often used by financial professionals as an alternative to net income and by business owners for valuation purposes, they are not recognized under generally accepted accounting principles (GAAP). Businesses sometimes provide them as a supplement to a company’s net income, but not as a substitute. Securities regulations require a public company to explain any differences between net income and EBITDA.

5. Cash flow

Cash flow is a record of money received and paid out by a business during a specific period. Unlike net income, it excludes some expenses such as capital expenditures and debt and interest costs. It is used to measure a business’s liquidity, or its ability to pay its bills.

Businesses record three types of cash flow:

Cash flow from operations

This is the most important of the cash flows because it shows whether the business is properly juggling payments from customers and its own cash payment obligations.

Cash flow from operations should be a positive number. If it’s negative, more money is flowing out than coming in, potentially leading to a cash crunch that could threaten a business’s survival.

Cash flow from operations is often analyzed alongside net income to evaluate a business’s financial situation.

Cash flow from investing

This is money used for buying assets or money received from selling assets. Examples of investing cash flow are purchases of manufacturing equipment (outflow) or the sale of a warehouse (inflow).

Cash flow from financing

Cash flow from financing includes money received from a loan or equity investment and money paid to lenders and investors, such as interest.

6. Capital

Capital represents the money you have in the bank, plus the money you have invested in factories, equipment, computers and software, patents, and other intellectual property. Capital consists of your money as well as other people’s money.

Your own money includes:

• Cash. Money or other financial resources.

• Retained earnings. The portion of a business’s net income that is reinvested in the business rather than paid to the owners or shareholders.

Other people’s money includes:

• Debt. Loans are the main type of debt a small business can take on. Interest and principal payments are a legal obligation. Lenders have no ownership stake in the business, though they often have a claim on its assets in the event of bankruptcy.

• Equity. Investors get an ownership stake in return for their money. They expect to receive distributions from the business’s profits or rising profitability to increase the value of their investment.

• Working capital. Working capital, or current assets minus current liabilities, measures a business’s cash on hand—or the cash it could obtain by converting investments to cash and collecting money owed by customers.

7. Balance sheet, and income and cash flow statements

Three main reports, or financial statements, provide information about a business’s condition and progress. They are:

Balance sheet

Also called a statement of financial position, the balance sheet tracks the value of assets (or what a business owns) and liabilities (or what it owes). It also includes equity, or net worth, which is the business’s value to its owners or shareholders. Equity is simply assets minus liabilities.

Income statement

Also called a statement of operations, the income statement shows how the business generated income and how it managed its expenses and liabilities to generate a profit in a specific period.

Net income is the most-watched figure in the income statement because it typically reflects a business’s long-term prospects of survival and growth. An income statement can be prepared on either an accrual basis (when the money is earned/spent) or or cash basis (when the cash changes hands). Most businesses prepare their income statements on an accrual basis.

Cash flow statements

Cash flow statements track how money moves in the business. These flows are compared to the income statement and balance sheet, helping find and reconcile any discrepancies.

For instance, say a business reports a higher quarterly net income on an accrual-based income statement than net cash from operations. It might reflect sales included in the income statement for which the actual payments are still pending. You can determine a business’s cash flow by adding back any non-cash items that appear in the accrual-based income statement.

8. Margins and ratios

Businesses can measure their results in absolute terms—the dollar value of revenue and profit, for example—or in relative terms with margins and ratios.

Margins

These are expressed as percentages, such as profit margin, which is the percentage of revenue remaining after subtracting expenses.

Ratios

These are typically expressed as multiples, such as the debt-to-equity ratio, which is how many times a business’s debt exceeds the owners’ equity. For example, a debt-to-equity ratio of two indicates that debt is twice as much as equity.

9. Returns

Returns refer to rates at which invested money increases in value or earns money. Some important returns for businesses include:

Return on equity (ROE)

ROE measures how effectively a business is using its investments. To calculate ROE, divide net income by shareholder equity (what’s left after subtracting liabilities from assets), and express it as a percentage. A higher ROE is better and means your business is utilizing its investments efficiently.

Return on investment (ROI)

ROI is what an investor gains on their money, expressed as a percentage.

If an investor puts in $10,000 in capital and sells the investment for $15,000, the ROI is [($15,000 - $10,000) / $10,000] x 100 = 50%.

Businesses use the same idea to evaluate their expected return when considering an investment to expand or make an acquisition. This is known as an internal rate of return analysis.

10. Growth

To understand how your company is growing, you need to take into account two concepts: sustainability and scalability. Sustainability is whether the business can continue to generate sales and profit over a long period of time. Scalability is about its ability to expand. This involves keeping costs under control and becoming more efficient and profitable because of economies of scale.

Financial analysts refer to the sustainable growth rate as the maximum growth rate a company can achieve without needing additional outside capital. It’s calculated as a company’s return on equity times its earnings retention rate, or the percentage of net income it keeps for reinvestment.

For example, if a company’s return on equity is 20%, and it retains 80% of earnings (or 0.8), its sustainable growth rate is:

20 x 0.8 = 0.16, or 16%

This means the business’s profit can grow as much as 16% a year before it needs to tap outside capital to grow faster.